The Dynamics of Incentive Contracts.

This paper studies a two-period principal/agent relationship run by short-term contracts. The principal updates the incentive scheme aft er observing the agent's first-period performance. The agent has superio r information about his ability. The principal offers a first-period incentive scheme and observes some measure of the agent's first-perio d performance (cost or profit), which depends on the agent's ability an d (unobservable) first-period effort. The central theme is that the ratchet effect leads to much pooling. For any first-period incentive scheme, there exists no separating equilibrium. The paper gives necessary and sufficient conditions for the existence of partition equilibria and looks at the effect of cost uncertainty. Copyright 1988 by The Econometric Society.