Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring

Tomasz Piskorski and Mark M. Westerfield
Journal of Economic Theory 2016, 166: 242-281

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Summary

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem. Our results help explain empirical findings on the linkage between termination, performance, pay-performance sensitivity, and monitoring.

Abstract

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Cite as

Piskorski, Tomasz, and Mark M. Westerfield. 2016. “Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring.” Journal of Economic Theory 166: 242–281. https://doi.org/10.1016/j.jet.2016.08.003

BibTeX

@article{PiskorskiWesterfield2016,
  author  = {Piskorski, Tomasz and Westerfield, Mark M.},
  title   = {Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring},
  journal = {Journal of Economic Theory},
  year    = {2016},
  volume  = {166},
  pages   = {242--281},
  doi     = {10.1016/j.jet.2016.08.003},
  url     = {https://doi.org/10.1016/j.jet.2016.08.003}
}

The PDF posted here is the authors’ manuscript (July 2016 draft). The version of record is available from the journal at the DOI above. Updated October 5, 2026.