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Working Papers

October 2016, No. 16-14R

Optimal Contracts with Reflection (Revised December 2017)

Borys Grochulski and Yuzhe Zhang

In this paper, we show that whenever the agent's outside option is nonzero, the optimal contract in the continuous-time principal-agent model of Sannikov (2008) is reflective at the lower bound. This means the agent is never terminated or retired after poor performance. Instead, the agent is asked to suspend effort temporarily, as in Zhu (2013), which brings the agent's continuation value up. The agent is then asked to resume effort, and the contract continues. Embedding this contracting problem in a simple search model, we show that a reflective lower bound arises endogenously if the agent is allowed to quit and find a new firm. Further, if the firm's commitment to the long-term contract is limited, a reflective upper bound arises as well.

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