Essays on Dynamic Contracts: Microfoundation and Macroeconomic Implications

This thesis consists of three chapters pertaining to issues of long-term relationships in labour markets. In Chapter 1, I analyze a model of a two-period advice game. The decision maker chooses to retain or replace the advisor after the first period depending on the first period events. Even though the decision maker and the advisor have identical preferences, this potential replacement creates incentive for the advisor to avoid telling the truth. I show the condition under which the decision maker can find a random retention rule that induces a truthful report from the advisor, and I characterize an optimal retention rule that maximizes the decision maker's expected payoff. In Chapter 2, I propose a search theoretic model of optimal employment contract under repeated moral hazard. The model integrates two important attributes of the labour market: workers' work incentive on the job and their mobility in the labour market. Even though all workers and firms are ex ante homogeneous, these two factors jointly generate (1) wages and productivity that increase with worker's tenure and (2) endogenous dynamic heterogeneity of the labour productivity of the match. The interaction of these factors provides novel implications for wage dispersion, labour mobility, and the business cycle behaviour of macroeconomic variables.Lastly, in Chapter 3, I quantitatively assess wage dispersion and business cycle implications of the model developed in Chapter 2. In terms of wage dispersion, the model with on-the-job search with wage-tenure contracts seems to accommodate sizable frictional wage dispersion. The model, however, generates very small productivity difference among workers, and shows weak evidence that the productivity difference generated by the endogenous variations in incentives is responsible for frictional wage dispersion. In terms of business cycle implications, workers' endogenous effort choice first amplifies the effect of productivity shock on unemployment rate. Second, responses of workers to productivity shocks generate marked difference between the effects of temporary productivity shock and that of permanent shock. Third, the analysis shows the importance of the distributional effect on macroeconomic variables during the transitory periods after a shock.