The Optimality of Quota Contracts

Abstract

A quota contract is known to be susceptible to the timing games by the agent. We show that this seemingly undesirable feature is what makes the use of quota contracts profitable for the principal who lacks contractual commitment power. A quota contract, by encouraging the agent's gaming activities, endogenously creates information asymmetry between the principal and the agent at the renegotiation stage, thereby curtailing the principal's temptation to renegotiate away any inefficient contractual punishment on the agent. Consequently, a properly designed quota contract enables the principal to save the overall agency cost by partially recovering the ability to implement dynamic incentives effectively.