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Working Papers

October 2016, No. 16-14R

Termination as an Incentive Device (Revised July 2019)

Borys Grochulski and Yuzhe Zhang

Although the dynamic agency theory predicts that the threat of termination should be an important incentive device mitigating moral hazard, empirical studies have not confirmed this prediction. Motivated by this discrepancy, we re-examine conditions under which termination is a part of an optimal long-term contract in the canonical dynamic moral hazard model of Sannikov (2008). We find that termination after poor performance is optimal only if incentives are lumpy and the agent has no outside options. When we relax either one of these arguably restrictive assumptions, we find that termination after poor performance is no longer a part of an optimal contract. In particular, termination is dominated by a temporary suspension of effort, which leads to reflective dynamics of the optimal contract.

 

*This paper was previously published under the title "Optimal Contracts with Reflection."

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