Reputation and screening in a noisy environment with irreversible actions

We introduce a class of two-player dynamic games to study the effectiveness of screening in a principal-agent problem. In every period, the principal chooses either to irreversibly stop the game or to continue, and the agent chooses an action if the principal chooses to continue. The agent’s type is his private information, and his actions are imperfectly observed. Players’ flow payoffs depend on the agent’s action, and players’ lump-sum payoffs when the game stops depends on the agent’s type. Both players are long-lived and share a common discount factor. We study the limit of the equilibrium outcomes as both players get arbitrarily patient. Nash equilibrium payoff vectors converge to the unique Nash equilibrium payoff vector of an auxiliary, two-stage game with observed mixed actions. The principal learns some but not all information about the agent’s type. Any payoff-relevant information revelation takes place at the beginning of the game. We calculate the probability that the principal eventually stops the game, against each type of the agent.