Implementing deterministic outcomes in stochastic dynamic environments

Abstract

In noisy environments with adverse selection and moral hazard, dynamic contracts can induce a risk-neutral agent’s actions to deterministically implement any one-shot, incentive-compatible outcome. Thus, dynamic contracts improve upon the static second-best when the principal’s payoff is concave in output, e.g., due to risk aversion or payoff concavity. We bring out a new intuition that applies to both principal–agent and limited commitment settings (such as Kyle, 1985)—in both settings, the informed agent can be induced to reveal all his private information.