Fintech Thrust Seminar | Punish Underperformance with Suspension — Optimal Dynamic Contracts in the Presence of Switching Cost
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Punish Underperformance with Suspension — Optimal Dynamic Contracts in the Presence of Switching Cost
Abstract:
This paper studies a dynamic principal-agent setting in which the principal needs to dynamically schedule an agent to work or to be suspended. When the agent is directed to work and exerts effort, the arrival rate of a Poisson process is increased, which increases the principal’s payoff. Suspension, on the other hand, serves as a threat to the agent by delaying future payments. A key feature of our setting is a switching cost whenever the suspension stops, and the work starts again. We formulate the problem as an optimal control model with switching and fully characterize the optimal control policies/contract structures under different parameter settings. Our analysis shows that when the switching cost is not too high, the optimal contract demonstrates a generalized control-band structure. The length of each suspension episode, on the other hand, is fixed. Overall, the optimal contract is easy to describe, compute, and implement.
Feng Tian is an Assistant Professor in the IIM area at HKU Business School. His research focuses on incentive design, including contract design, information design, and market design. His papers have been published/accepted at Management Science and Operations Research. Dr. Tian received his Ph.D. degree in Technology and Operations from Ross School of Business, University of Michigan, Ann Arbor.