Timing of Effort and Reward: Three-sided Moral Hazard in a Two-Period Model ∗

Business often needs to face the problem of providing incentives for employees to work together effectively on projects that develop over time. This paper derives the optimal contract in an intertemporal model with three-sided moral hazard. The optimal timing of com-pensation reflects the timing of effort, with compensation for upfront effort preceding compensation for effort over time. Deferring compen-sation for agents exerting effort over time improves their incentives without impairing incentives for upfront effort. The exact pattern of compensation depends on the relative severity of the agents ’ incentive problems. ∗I am especially grateful to Philip Dybvig for his invaluable comments and discussions. I would also like to thank Kerry Back, Vladimire Mares, Todd Milbourn, and Chakravarthi Narasimhan for their helpful suggestions. All errors remain of course my responsibility