Optimal Dynamic Contracts with Hidden Actions in Continuous Time. Working paper

I consider a dynamic hidden action problem in continuous time, and I present a general method for solving such problems. In a model with non-separable intermediate utility and the possibility that the agent earns observable outside income or perks, I show how the optimal contract can be written as a function only of the agent’s financial wealth and implemented actions. I then show that the principal’s choices of intermediate consumption and effort level have a real option property that has no analog in static or linear contracting models: the principal will employ the agent at a loss, hoping conditions improve, in order to keep the option of future employment open. Finally, I show how to relax the level of commitment to allow for state contingent employment termination and time-inconsistent incentives