Dynamic Incentive Theory

Models seen in macro course focused on dynamic resource allocation

(consumption-savings, investment, employment, insurance, asset markets…)
while abstracting from incentive problems or agency conflicts.

Gave rise to stark benchmark results, but abstracts from potentially important
incentive issues.

Most importantly, dichotomy between “micro” and “macro” dynamics due to

full insurance of idiosyncratic consumption risk.

Two possible ways to break the dichotomy, and allow for meaningful micro
heterogeneity:

A. Incomplete Markets (in Eugenia’s course): introduce ad hoc restrictions

on insurance from idiosyncratic risks => “precautionary savings” with
limited set of assets/instruments.
B. Dynamic Contract Theory (this course): Motivate limited insurance from
first principles, i.e. through the presence of agency frictions

Objective of this course:

- Introduce agency frictions into core macro => Dynamic incentive theory
- Explore dynamic tradeoffs between incentives and insurance motives
- Discuss to what extent these tradeoffs shed new light on applications:
(i) positive applications (risk-sharing, social mobility, asset pricing…)
(ii) optimal policy design (social insurance, taxation,…)

Along the way, develop mathematical tools for integrating dynamic general
equilibrium and incentive theory => Merge tools you developed in core macro
(consumption-saving, GE) with tools from your core micro courses (static
contract and game theory).
Dynamic Moral Hazard

Optimal Unemployment Insurance

An unemployed worker is searching for a job. How should a social planner

design insurance against a prolonged unemployment spell while encouraging
the worker to actively search for a new job?

Assumption: Search effort is unobservable => Dynamic Moral Hazard

Tradeoff between (i) incentivizing job search vs. (ii) providing insurance against
risk of remaining unemployed and liquidity for consumption-smoothing

1. Hopenhayn-Nicolini, JPE 1997

- Use dynamic/recursive contracting approach to characterize optimal

insurance design

- Calibrate the model to quantify potential cost savings or welfare gains from
switching to an optimal insurance scheme

Key insights:

(1) Optimal scheme conditions benefits and social insurance contributions on

unemployment duration

(2) Optimal scheme facilitates consumption-smoothing in short run

(3) Technical insight: use of “promised utility” as state variable in dynamic

contracting problem (similar to Abreu-Pearce-Stacchetti in repeated games)

The model

Risk-neutral planner/principal

Risk-averse unemployed agent with per period utility u(c) - a

where: c = consumption, u(c) is increasing and concave

a = search effort, job finding probability p(a) is increasing and concave

p(a) = probability the worker finds a job at wage w>0. Once employed, worker
keeps job forever.

Common discount factor β<1

Events and Histories

s0 = U (worker starts unemployed)

s1 = E w.p. p(a0) or U w.p. 1-p(a0)

s1 = (U, E) or (U, U)

s2 = E w.p. p(a1) or U w.p. 1-p(a1) etc.

2 possible cases in period t:

(i) the worker is still unemployed: st = (U, U, ..., U)

(ii) the worker found a job at s≤t: st = (U, U,...,U, E, E,...,E)

Dynamic contract

Specifies history-contingent sequence {ct, at} of consumption and search effort.

Different cases:

(i) Autarky (consumption = income)

(ii) First-best contract: planner observes at

(iii) Second-best contract: planner does not observe at

(iv) Status quo system: Agent receives benefits at 2/3*w for T=26 weeks
(needed for quantitative evaluation)

i. Autarky

Step 1: Value upon employment

Ve = 1/(1-β)*u(w)

Step 2: Optimal search while unemployed

VU = maxa{u(0) - a + βp(a)Ve +β(1-p(a))VU}

FOC for a: 1 = β*p'(a)(Ve - VU)

Discussion (Autarky case):

Easy to check that Ve>VU.

At autarky, ct =0 while unemployed, ct = w after finding a job

=> No consumption-smoothing/insurance, maximal provision of incentives

ii. First-best contract with observable a:

Recursive formulation using agent's continuation value as state variable in

planner's problem (Pareto frontier between planner and agent).

Step 1 (After employment):

Planner's problem is to set {cs} to minimize ̅ ( )=∑ ( − ) while

delivering value =∑ ( ) to agent

Recursive formulation: ̅ ( ) = min , { − + ̅ ( )}

subject to u(c)+βV' = Ve (P-K)

Solution: V'=Ve=1/(1-β)*u(ce), ̅ ( )=

After reemployment it is optimal to fully smooth consumption level ce

consistent with promised utility Ve. => w-ce is tax on income after
reemployment.

Step 2 (While unemployed):

−
( ) = min + ( ) + 1− ( ) ( )
, , , 1−
( )
subject to: ( )− + ( ) + 1− ( ) = (P-K)
FOCs: 1=λ*u'(c)=λ*u'(ce) => c=ce

Note: λ is multiplier on (P-K)

FOCs (Ctd): 1− ( ) ( )= 1− ( )

Together with envelope condition ( )=

=> ( )= = ′( ), so V = VU

Therefore: at first-best contract, we obtain perfect insurance/consumption

smoothing, constant consumption regardless of unemployment status, and
constant search effort while unemployed.

iii. Second-best contract when a is unobservable

Recursive formulation using agent's continuation value as state variable in

planner's problem (Pareto frontier between planner and agent), adding
incentive compatibility constraint to the problem.

Step 1 (after reemployment): no more moral hazard, so the same as before

Step 2: While unemployed

−
( ) = min + ( ) + 1− ( ) ( )
, , , 1−
( )
subject to: ( )− + ( ) + 1− ( ) = (P-K)

1= ′( )( − ) (IC)

Moral Hazard: Incentive Compatibility <=> "Obedience"

Planner makes recommendation a for search effort

Agent finds it optimal to follow planner's recommendation (IC constraint)

FOC's: 1=λ*u'(c) and 1=u'(ce)*{λ + η* p'(a)/p(a)}

=> Since η>0 (multiplier on IC constraint), it follows that ce > c, i.e. consumption
increases upon re-employment

C'(VU) = λ - η * p'(a)/(1-p(a)) and envelope condition C'(V) = λ:

It follows that C'(VU) < C'(V), and from convexity of C, V > VU.

Therefore:

Ce > C Agent experiences increase in consumption after finding a job

VU < V Continuation values decline while agent remains unemployed

C'(V) = λ = 1/u'(C) Consumption declines while unemployed

Explanation: Efficient Incentives  Likelihood Ratio Principle  Efficient to

lower consumption at histories that have higher likelihood with low search
effort

Longer unemployment spell more likely if search effort is low

=> optimal to have lower benefits, higher tax after longer U-spell

=> LR principle implies declining unemployment benefits, increasing

employment tax for longer unemployment spells.

iv. Current system (needed for quantitative exercise)

Allow for standard consumption-savings with risk-free asset at return R=1/β,

constant benefits at b=2/3 * w for t < T=26 weeks, b = 0 thereafter.

Step 1: After finding a job, Ve(s) = 1/(1- β) * u(w+(R-1)s)

=> optimal to have constant consumption c=w+(R-1)s

Step 2: While unemployed, but after running out of benefits (t≥T):

VT(s) =maxc,a,s'{u(c) - a + βp(a)Ve(s')+β(1-p(a))VT(s')}

where s' = R*s - c.

Step 3: While unemployed but before running out of benefits (t<T)

Vt(s) =maxc,a,s'{u(c) - a + βp(a)Ve(s')+β(1-p(a))Vt+1(s')}

where s' = b + R*s - c.

Quantitative Evaluation

- Calibrated to weekly data => β=0.999 (ca. 5% annual discount rate)

- w=100 (normalization)

- existing US system: b = 66 for 26 weeks

- u(c) = c1-σ/(1-σ), with σ=1/2, high short-run IES

- p(a) =1-e-ra, where r is calibrated so that autarky model displays a job-finding

hazard of 10% per week

=> in line with empirical estimates after expiration of benefits

Optimal system (Table 1 in H-N)

Replacement ratio and Ce almost linearly declining by 0.1 per week of

unemployment, from 99 and 100.5 (small subsidy of 0.5 for finding a job
immediately) in week 1 to 97.5 and 99 after 16 weeks, 96.5 and 98 after 26
weeks, and 94 and 95.5 after 52 weeks

Note big difference if there is no tax upon reemployment:

Decline of consumption from 85.8 in week 1 to 80.8 in week 2, 58.4 in week 8,

40.5 in week 16, 27.7 in week 26, and 13. 4 in week 52

Substantial difference due to the fact that reemployment tax helps smooth
consumption, and frontload incentives for job search (figure 3)

Also: substantial cost savings, relative to current system (30% with

reemployment tax, 8% without tax - table 3, first column)

Conclusion
Paper provides a nice example of using recursive contracting methods to
analyze a problem of optimal policy design with moral hazard => Notice
dynamic programming problem using worker utility as state variable

Novel insight on policy design: role of taxes that are contingent on

unemployment duration for efficient insurance-incentive tradeoff

Quantitative policy evaluation: using current policy system as benchmark for

calibration, evaluate potential welfare gains or cost savings from shifting to an
optimal policy design (common approach in quantitative policy evaluation: use
status quo as benchmark to then run optimal policy counterfactual)

Discussion

1. Two distinct roles for unemployment insurance in the model:

Insurance (against risk of remaining unemployed) vs. liquidity/short-run

consumption smoothing

Optimal scheme entails large degree of consumption smoothing, notice

uniform declines in permanent consumption with the length of unemployment
duration => similar to a consumption loan while unemployed that needs to be
reimbursed once the worker finds a job!

=> Shimer-Werning (AER 2008, next paper): implementation with constant

benefit b and reemployment tax t, coupled with precautionary savings,
separate incentive and insurance provision (tax and benefit) from liquidity
provision (precautionary savings).

2. Only risk considered in the model: unemployment duration (relatively short

term in the US, average spell is less than 4 months!)

This should be easy to smooth through precautionary savings

Much bigger risks associated with unemployment: loss of human capital, lower
wages upon finding a new job, longer delay in finding new job opportunities,
need to switch careers etc. "Human capital depreciation"
2. Liquidity and Insurance for the Unemployed (Shimer and Werning, AER
2008)

- Allow for savings by agents to disentangle "Liquidity" from "Insurance"

component of unemployment insurance

- Formalize the intuition that optimal unemployment insurance is similar to

precautionary savings or short-term consumption loan (if savings are negative)

- Implementation of optimal dynamic contract through precautionary savings

with constant tax and benefit policy with CARA preferences.

- Analysis based on search process as "sampling" from a distribution of

wages/job offers (rather than hidden search effort)

- Published paper discusses continuous time version of their model, here we

develop equivalent discrete time treatment

The set-up

Same basics as Hopenhayn-Nicolini (1997): risk-neutral planner, risk-averse

agent, common discount factor β<1

At the beginning of each period, agent samples a wage offer ~ (∙), can
either accept or reject the offer (minor timing modification relative to H-N)

Moral Hazard: Planner observes only the employment status but not the wage
offers or earnings.

Interest rate r such that (1+r)β=1

Agent preferences: u(c)=-e-χc (CARA) for analytical solutions, CRRA for

numerical analysis

Two useful properties of CARA: (i) u(c1+c2)=-u(c1)*u(c2) and (ii) u'(c)=-χu(c)

i. The Planner's problem:

Planner sets sequence {bt, tt} of benefits bt if worker remains unemployed in

period t, and tax tt upon re-employment if worker accepted a job in period t.

Worker determines a sequence of reservation wages { }, such that they

accept a job in period t, only if the wage offer exceeds the reservation wage.

Moral Hazard: a higher level of benefits and re-employment taxes induces the
worker to raise their reservation wage.

Planner's Cost and Agent's Value

Planner's cost for given { , ; }:

({ , ; }) = ∑ ∏ ( ) ( )− 1− ( )

Agent's utility for given { , ; }:

( − )
({ , ; }) = ( ) ( ) ( )+ ( )
1−

If worker is still unemployed after period t-1: (w.p. ∏ ( )), worker can
either reject the new job offer and claim benefits (w.p. ( )) or accept the
new job offer if it exceeds the reservation wage.

Planner problem: ( ) = min{ , ; } ({ , ; })

subject to: ({ , ; }) = (P-K)

({ , ; }) ≥ ({ , ; }) for all { } (IC)

(IC) <=> Obedience: Agent must find it optimal to apply reservation wages
recommended by the planner.
CARA implies no wealth effects for incentives:

CARA property (i) implies that ({ + , − ; }) = − ( ) ({ , ; })

for any x and any { , ; }.

In addition ({ + , − ; }) = ({ , ; }) + .

Moreover, adding this constant x to consumption in every period doesn't affect

IC-constraints: If ({ , ; }) ≥ ({ , ; }), then

({ + , − ; }) = − ( ) ({ , ; }) ≥ − ( ) ({ , ; })
= ({ + , − ; })

Furthermore, we show that if { , ; } is optimal for a utility promise V, then

{ + , − ; } is optimal for a utility promise = − ( ) .

Proof: Suppose { , ; } is optimal for V and , ̃; is optimal for

=− ( ) .

Since − , ̃ + ; also implements promise V: − , ̃ + ; =

, ̃; − ≥ ({ , ; }).

Since { + , − ; } also implements promise : ({ + , −

; }) = ({ , ; }) + ≥ , ̃;

Combining the two inequalities: , ̃; − = ({ , ; }) and

{ + , − ; } is optimal for = ( ) , and vice versa.

This already leads to two observations about the optimal contract:

1. There exists an optimal plan in which the reservation wage is time-

invariant ( = for all t) and benefits and reemployment taxes vary with
unemployment duration.

2. The planner's cost function takes the form ( ) = ( ) + , where

= − ( ) , or equivalently = (− ) − (− ) . The marginal

cost is ( )= (note: u(x)<0 and hence V<0)

( ) ( )
Recursive Formulation

( ) = min + ( ′) ( )− 1− ( )
, , , 1−
( )
subject to: =( ( )+ ′) ( ) + ∫ ( ) (P-K)

( )
( )+ = (IC)

The (IC) constraint requires that the agent is just indifferent between accepting
and declining a job offer at the reservation wage. Then higher wages are always
accepted, and lower wages are always rejected.

Before taking FOCs, we substitute (IC) into (P-K) to rewrite (P-K) as follows:
( ) ( ) ( )
= ( )+∫ ( )= ∆( ) (P-K)

where ∆( ) = − ∫ ( { − , 0}) ( ). Notice that 0 < ∆( ) < 1.

First-order conditions and optimal dynamic contract

Now, take FOCs for b and V': ( ) = ′( ) and ( ) ( ) = . Combine

with CARA fact (ii) and the previous definition of ( ) to obtain: ( ) =
( )
− =− ( )
= (1 − ) ′.

Substituting this equation into (IC): ( ) = ( − ), and therefore = + .

Substituting this equation into (P-K): ( ) = (1 − ) /∆( ).

Therefore, for given V and , the optimal contract satisfies = < ,

∆( )
= (1 − ) /∆( ) , and = − .

Applying these results recursively, the sequence { , , } satisfies:

= + ∙ ∆( ), = − ∙ ∆( ), and = /∆( ) .

In addition, when the worker accepts a job, consumption increases by

− − = − , and then stays flat forever.
To summarize: the optimal dynamic contract is implemented by a constant
reservation wage, unemployment benefits that decrease by constant
increments − ∆( )/ and employment taxes that increase by the same
constant increment − ∆( )/ for each additional period of unemployment.

Upon accepting a job, consumption increases by − and then stays flat.

Optimal reservation wage determined by taking FOC after substituting the

solution for V', b and t.

ii. Self-insurance with constant benefit b and reemployment tax τ

Here we show that this optimal contract can be implemented with constant
taxes and benefits, along with access to riskfree savings.

Step 1 (employed): ( ; ) = max − + − ′ + ( ′; )

( , )
=> ( , )= − + −1 (constant over time), ( ; )=

Step 2 (unemployed):

( , )
( ) = max + − ′ + ( ′) ( )+ ( )
, 1−

Conjecture: ( )= for some constant K to be determined.

Verification: with guess, a' satisfies + − = −1 + +

or = − . This gives + − ′ + ( ′) = , and

1 1
( )= ( , ) , −1 + + ( )
1−
1
−1 + +
{ , }
= ( )
1−
 ( )
where = + + . This confirms the conjecture with = 1/
∆( ). It is easy to check that K > 0.

Optimal self-insurance scheme

The optimal consumption savings scheme then has the following properties:

- Assets a decline in constant increments .

- Consumption while unemployed declines in constant increments (1 − ) =

− ∆( )/ , the same as at the optimal dynamic contract.

- Consumption when unemployed is −1 + + , but jumps to

−1 + − after accepting a job. Hence consumption increases by

− after accepting a job, the same as at the optimal dynamic contract.

- The reservation wage is independent of a and only depends on b+t:

+ = − = +( )
∆( )

Since ∆ ( ) > 0, there exists for each a unique + < that implements
as the worker's reservation wage.

=> By choosing b+t appropriately we implement the reservation wage of the

optimal dynamic contract.

- If a0 is given: holding b+t constant, an increase in b and reduction in t are

isomorphic to an increase in initial assets (Ricardian Equivalence), so the
planner can implement any V0 by adjusting the initial benefits and taxes.

To summarize: Optimal dynamic contract is implementable with consumption-

savings and a constant tax/benefit policy (b,t).

=> For any promised value V0 and initial asset position a0, there exists a
constant benefit and tax policy (b,t) that implements the optimal dynamic
contract from V0 with consumption-savings decisions out of an initial stock of
assets a0.
Comments:

1. Liquidity constraints: Absence of liquidity constraints (binding lower bound

constraint on asset holdings) - otherwise asset market ceases to provide
consumption-smoothing. (In practice, liquidity constraints likely to be
important in short-run unemployment spells).

With liquidity constraints (lower bound on asset positions), the optimal scheme
could be implemented as follows: (i) constant b and t chosen to implement
optimal while liquidity constraints are not binding, (ii) once liquidity
constraints bind, b and t adjust in steps to provide optimal consumption path,
and (iii) no suspension of interest payments on outstanding debt.

=> Unemployment insurance substitutes for lack of financial flexibility by

providing "loans" that are secured against future labor income.

2. Quantitative results: With CARA preferences, there are no wealth effects of

asset holdings on incentives.

Shimer and Werning show numerically that these are small in a model wiht
CRRA preferences. With consumption-savings, optimal benefits and taxes are
almost constant for short (<4y) unemployment spells. Potential welfare gains of
moving from a constant tax-benefit system with savings to the optimal system
are negligible.

Other applications of dynamic moral hazard:

Dynamic Lending contracts and firm dynamics

Clementi and Hopenhayn (QJE 2006) -- dynamic moral hazard friction to

account for financial frictions and growth dynamics of start-up firms

Biais, Mariotti, Plantin and Rochet (REStud 2009) -- similar model and friction,
decentralization through set of financial instruments (equity, loans, and lines of
credit)