No 1055 June 2011 Recursive Contracts

We obtain a recursive formulation for a general class of contracting problems involving incentive constraints. These constraints make the corresponding maximization (sup) problems non recursive. Our approach consists of studying a recursive Lagrangian. Under standard general conditions, there is a recursive saddle-point (infsup) functional equation (analogous to a Bellman equation) that characterizes the recursive solution to the planner's problem and forward-looking constraints. Our approach has been applied to a large class of dynamic contractual problems, such as contracts with limited enforcement, optimal policy design with implementability constraints, and dynamic political economy models.

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