When to Fire a CEO: Optimal Termination in Dynamic Contracts

Existing models of dynamic contracts impose that it is both optimal and feasible for the contracting parties to bind themselves together forever. This paper introduces optimal terminatin in dynamic contracts. We modify the standard dynamic agency model to include an external labor market which, upon the dissolution of the contract, allows the firm to return to the labor market to seek a new match. Under this simple closure of the model, two types of terminations emerge. Under one scenario, the agent is fired after a sequence of bad outputs and she becomes too poor to be punished effectively. Under the second scenario, the agent is forced out after a sequence of good outputs and she becomes too expensive to motivate. We then use the model to study issues of CEO termination and firm dynamics.