Using Persistence to Generate Incentives in a Dynamic Moral Hazard Problem

This paper studies how persistence can be used to create incentives in a
continuous-time stochastic game in which a long-run player interacts with a se-
quence of short-run players. Observation of the long-run player's actions are
distorted by a Brownian motion and the actions of both players impact future
payoffs through a state variable. For example, a firm or worker provides customers with a product, and the quality of this product depends on both current
and past investment choices by the firm. I derive general conditions under which
a Markov equilibrium emerges as the unique perfect public equilibrium, and char-
acterize the equilibrium payoff and actions in this equilibrium, for any discount
rate. I develop an application of persistent product quality to illustrate how per-
sistence creates effective intertemporal incentives in a setting where traditional
channels fail, and explore how the structure of persistence impacts equilibrium
behavior. This demonstrates the power of the continuous-time setting to deliver
sharp insights and a tractable equilibrium characterization for a rich class of
dynamic games.

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Paper Number
16-024
Year
2016
Authored by