Optimal Dynamic Contracting

We study a simple dynamic Principal-Agent model in which the agent?s types are serially correlated. In these models, the standard approach consists in first solving a relaxed version in which only local incentive compatibility constraints are considered, and then in proving that the local constraints are sufficient for implementability. We show that, with the exception of few notable examples highlighted in the literature, this approach is not generally valid: even assuming standard regularity conditions, both local and global incentive constraints are generally binding when serial correlation is sufficiently high. We uncover a number of interesting features of the optimal contract that cannot be observed in the special environments in which the standard approach works. Finally, we show that even in complex environments, approximately optimal allocations can be easily characterized by focusing on a particular class of contracts in which the allocation is forced to be monotonic.