Long-Term Contracts and Moral Hazard

Author(s): Richard A. Lambert

Source: The Bell Journal of Economics, Vol. 14, No. 2 (Autumn, 1983), pp. 441-452
Published by: RAND Corporation
Stable URL: http://www.jstor.org/stable/3003645 .
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Long-termcontractsand moralhazard
Richard A. Lambert*

This articleextends the economictheoryof agency to a simple class of multiperiodsitu-

ations.In this contextwe studythe role of long-termcontractsin controllingmoralhazard
problems. We characterizethe optimallong-termcontract,and show that even whenthe
"environment" is separableovertime, the agent'scompensationin one period will depend
on his performancein thatperiod and his performancein the priorperiods.

1. Introduction
* The economictheoryof agencyprovidesa frameworkfor studyingsituationsin which
a personor a groupof people delegatesthe selectionof an action to anotherindividual.
Much of the workin agencytheoryhas been done in a single-periodcontext (Ross, 1973,
1974; Harrisand Raviv, 1978, 1979; Mirrlees,1974, 1976; Holmstrom, 1979; Shavell,
1979;Grossmanand Hart, 1983). Little is known about the extent to which the insights
and conclusionswhichhavebeenderivedin single-periodsettingsgeneralizeto multiperiod
relationships.
The purposeof this articleis to take a preliminarystep in extendingagency theory
to multiperiodrelationships.Our analysis differs in several respects from multiperiod
agency problems studied elsewhere.Radner (1980) and Rubinstein and Yaari (1980)
examine infinite horizon models in which the same single-periodsituation is repeated
over time. In addition,they do not allow utilitiesto be discountedover time. In contrast,
we analyzeagencyrelationshipswhich last (a maximum of) T periods,where T is finite.
Our productionfunctionsare requiredto be separableover time; however,we do allow
the productionfunctionsto change in a deterministicfashion over time. We also allow
the principaland the agent to discount their utilities.
Radner(1981) considersa model in which the same one-periodsituationis repeated
a finite numberof times. He analyzes strategieswhich form an "approximate"equilib-
rium, called an epsilon equilibrium.He shows that if the principaland the agent do not
discount their utilities and if T is large enough, these strategiesallow them to come
arbitrarilyclose to the infinitehorizonresults.We discussthe infinitehorizonresults,and
comparethem with our own in Section 4.
Our approachis to derive optimal equilibriumstrategiesin a game in which a type
of binding precommitmentis allowed. In particular,we examine the role of long-term
contractsin controllingmoralhazardproblems.By offeringthe agenta long-termcontract,
the employerhas a mechanismfor precommittingto a strategythat is feasible,legal, and
bindingwithin our institutionalframework.We initiallyassume that the agent also pre-
commits to the long-termcontract by guaranteeingto remain with the firm for all T
periods.We derive the optimal long-termcontract, and we find that the agent's com-

* Northwestern University.
I would like to thank Amin Amershi, Rick Antle, Joel Demski, Mark Wolfson, an anonymous referee,
and the Editorial Board for their helpful comments. The financial support of the Accounting Research Center
of the J.L. Kellogg Graduate School of Management is gratefully acknowledged.

441

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442 / THE BELLJOURNALOF ECONOMICS

pensationin one perioddependson his performancein that periodand his performance

in the prior periods.We interpretthis as the principal'susing the agent's performance
over the entire history of his employment to diversifyaway some of the uncertainty
surroundingthe agent'sactions.
We then relax the assumptionthat the agent precommitsto a long-termcontractby
allowinghim to leave the firmif it is in his best intereststo do so. We find that this limits
the penalties that the principal can impose upon the agent; however, the optimal long-
term contract still causes the agent's compensation to depend on both his current per-
formance and his past performance.

2. The model
* To keep the analysissimple, we shall restrictourselvesto a two-periodmodel. At the
end of Section 3, we shall indicatehow to extend the analysisto more than two periods.
In each period the agent selects an action, a, E A,. This action, in conjunction with a
randomstate of nature,producesa cash flow, x,. We assume that X,, the set of possible
cash flows in periodt, is a finite set. The cash flow in each periodcan be representedas
a randomvariablewhose distributiondepends on the actions taken by the agent. Let p,
denote the probabilityfunction for the period t cash flow. We assume that the state
variablesare independentlydistributedover time, and that effort in one period has no
effecton the cash flow in any other period. We can write

Prob(x,, x21a1,a2) = p1(xla,)p2(x21a2).

The probabilityfunctionsare assumedto be differentiablewith respectto the agent's

effort. Let p'(x,la,) denote this derivative.We also assume that increasedeffort in one
period shifts the distribution of that period's cash flow to the right in the sense of first-
orderstochasticdominance. The supportsof the outcome distributionsare assumed to
be independentof the agent'seffort.This implies that p,(x,la,)> 0 for all x, E X, and for
all a, E A,. This ensures that the principalcannot use the cash flow to determine un-
ambiguouslythe agent'sactions. The outcome distributionsare assumedto be known to
both parties.
We do not necessarilyassumethat each period'scash flow has the same distribution.
The productionfunctioncould changein a deterministicfashionover time. For example,
the productionfunctionscould be an increasingfunctionof t, all otherthingsequal. This
mightrepresentthe agent'sbecomingmore skilledat the job over time. Alternatively,the
productionfunction might be a decreasingfunction of time to reflectdepreciation.
The principal'sstrategyspecifieshow the agent will be compensatedin each period.
The agent'scompensationcan depend on any variablesthat arejointly observableat the
time thatpaymentis to be made.At the end of periodt, the agent'sperformancein periods
one throught is known. Let s,(xl, . .. , x,) E [s,, s,] E JRdenote the agent'spaymentin
period t when his performance in periods one through t is (x,, . . ., x,). We can define a
strategyfor the principalas a sequenceof functions,s = {s,(x,), s2(x1,x2)}.
The agent's strategy is to decide how much effort, a, E A, = [a,, a,J E JR, to supply
in each period.Note that the agent'schoice of effortcan depend on his performancein
the priorperiods.A strategyfor the agentcan thereforebe representedas a = {a,, a2(x1)}.
Becauseof the assumptionthat each X, is a finite set, the strategiesof the principaland
the agent can be representedas points in finite dimensionalEuclideanspaces. Problems
associatedwith choosingstrategiesfrom infinitedimensionalspacesare therebyavoided.
We initiallyassumethat both the principaland the agent precommitto a two-period
contract.At the beginningof the first period, the principalchooses the contract,s. The
agentthen respondswith his effortstrategy,a. Note that the agentguaranteesthat he will

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 LAMBERT / 443

remainwith the firm for both periods.Figure 1 illustratesthe sequenceof choices in the
model.
The principaland the agent are assumedto possess utility functions which are ad-
2

ditively separableby periods.The principal'sutility function is ZGx, - s,], and the

2

agent'sis E {U,(s,)- V,(a,)}.These utilityfunctionsare permittedto varywith time. For

example,we allow utilitiesto be discountedover time.
The principal'speriod t utility function, G,(*), is defined solely over the cash he
receives from the agency. As usual, he is assumed to like money and be risk averse
or risk neutral:GX(.) > 0 and G'(.) < 0. The agent's period t utility function is
assumed to be separable into an income component and an effort component:
H,(s, a) = U,(s) - V,(a). He prefers more money to less, U,( ) > 0, and is strictly risk
averse, U',(.) < 0. He dislikeseffort, V,(a) > 0, and his effortaversion increasesat an
increasingrate, V,(a) > 0.
We furtherassume that the income receivedin period t may only be used for con-
sumptionin that period.We do not allow a portionof the income receivedin one period
to be savedandthen consumedin a laterperiod.Also, we assumethat neitherthe principal
nor the agent is endowedwith any other source of income duringthe T periods.These
assumptionsare, of course,unrealistic;however,they appearto be necessaryto make the
analysistractable.
When the strategypair (s, a) is used, define
2
G(s, a) = E[ z G,[x, - s,(x,, . .. , xj)]]
t= 1
and
2
H(s, a) = E[ II,[s,(x1, . .. , xt), at(x1, . .. , xt,1)J]
t= 1

to be the expectedutilitiesof the principaland the agent,respectively,over the two-period

horizon, as assessedat the beginningof period one. When both the principaland the
agent precommitto a long-termcontract,we can write the principal'sproblemas
max G(s, a) (1)
(s,a)
subjectto
a E argmaxH(s, a)
H(s, a) 2 0.
The firstconstraintrequiresthe agent'sstrategyto be a best response,or incentive
compatible,to the principal'scontract.The second constraintrequiresthe employment
contractto give the agent an expected utility of at least 0 over the two-periodhorizon,
when viewedfromthe beginningof periodone. 0 could representthe utilitylevel that the
agent could achieve over the two-periodhorizon if he did not precommitto remaining

FIGURE1
TIME LINEFOR CHOICES

PERIOD1 PERIOD2

PRINCIPAL AGENT BOTH AGENT BOTH

CHOOSES CHOOSES OBSERVE CHOOSES OBSERVE
S1(X1), s2(x1,x2) a1 X1a2(x1 )x

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444 / THE BELLJOURNALOF ECONOMICS

with the firm.For example,this could representthe agent'sexpectedutilityover the two-

periodhorizonwhen the labor marketuses a given wage revisionprocess.
Subjectto these two constraints,the principalis free to updatethe agent'scompen-
sationover time in any fashionthat he desires.For example,the principalcan designthe
contractso that E[H2[s2(x,,x2), a2(x,)IIxI is an increasingfunction of x,. The optimal
mix betweencurrentperiod incentivesand future period incentiveswill be determined
endogenously.Note thatthe principalis allowedto choose the same wagerevisionprocess
that the externallabor marketuses. If the internalwage revision processchosen by the
principaldoes not eliminate the incentive problem, neither can an externallyimposed
wagerevisionprocess.For this reason,we can examine whetherthe "ex post settlingup"
phenomenonsuggestedby Fama (1980) can occur in our model.
Beforestudyingthe noncooperativegame formulatedin problem(1), we shallbriefly
discussthe solutionto this problemwhen the firstconstraintis ignored.This gives us the
solutionto the principal-agentgame in the absenceof incentiveproblems.Becauseof the
separabilitythat is built into the model, it is easy to show that, in the absenceof incentive
problems,thereis no reasonto make the (sharingrule, action) pair chosen in one period
depend on anythingthat occurredin the prior periods. This implies that the optimal
contractwill satisfyG,[x, - s,(xt)]= XU,[s,(x,)],where Xis the Lagrangemultiplieron the
agent'sminimum utility constraint.

3. Solution to the noncooperative problem

* We can simplifythe agent'sincentivecompatibilityconstraintconsiderablyby using
a dynamicprogrammingapproachto determiningthe agent'sstrategy.When the agent
getsto thesecondperiod,he willchoosehiseffortoptimallyconditionaluponthe information
that he has at that time. Becauseof the separabilityof the productionfunction and his
utilityfunctionover time, the agentdoes not needto rememberwhathis first-periodeffort
was when the time comes for him to select his second-periodeffort.Given his optimal
second-periodstrategy,he chooses his first-periodaction to maximize his expectedtwo-
periodutility.The incentivecompatibilityconstraintcan thereforebe expressedas
a2*(x,)E argmaxEH2[s2(x,, x2) a2] for each x, (2)
a2

a*' E argmaxE[H,[s,(x,), a,] + H2[s2(x,, x2), a2*(x,)]]. (3)

ai

Note that since S2 may depend on x,, the agent'schoice of a2 may also depend on
the first-periodoutcome. That is, the function s2(x2)may be parameterizedby the first-
periodoutcome. If this is the case, the agent is facinga differentsecond-periodcontract
for differentx,'s. A differentsecond-periodaction may thereforebe optimal for different
first-periodoutcomes. Also note that since a, affectsthe distributionof x,, it may affect
the distribution(as assessedat the beginningof period one) of which a2 will be selected.
Since the argmaxconditions as listed in constraints(2) and (3) above are difficult
to work with, we make the simplifyingassumptionthat the agent's choice of effort in
eachperiodcan be representedby his first-orderconditionon effort.'Assumingan interior
solution for a, and a2(x,) for all xl, the agent will choose his effortto satisfy:

'Grossman and Hart (1983) discuss problems associated with modeling the agent's actions by using his first-
order conditions. It is possible to derive restrictions on the distribution functions to ensure the concavity of the
agent's expected utility with respect to his effort. For example, Lambert ( 198 1) shows the if the distribution satisfies
the monotone likelihood ratio property and the cumulative distribution function is a concave function of the
agent's effort, the argmax constraints in equations (2) and (3) can be replaced by the corresponding first-order
conditions. The results of the article also go through using Grossman and Hart's approach to modeling the agent's
action choice.

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 LAMBERT/ 445

z U2[s2(x1,x2]p'2(x2la2(x1))
- [a2(XI)] = 0 for each xi (4)
E {UI[sI(xi)] + EH2[s2(x1, x2), a2(x1)]}p' (x,1la,)- V(a,) = 0. (5)
Equation(4) is analogousto the agent'sfirst-orderconditionon effortin a one-period
model. The agent selects his effort so that its effect on his expected marginalutility of
income is equal to his marginaldisutilityof effort.Equation(5) is similarto (4) except
that the agent must also considerthe effect that a, has (throughits effect on x,) on his
second-periodeffortand second-periodincome.
Assumingwe can representthe agent's choice of effort by the correspondingfirst-
order conditions,we now replaceconstraint(2) in the principal'sproblemby equation
(4) and constraint(3) by (5). We furtherassume that we can representthe principal's
problemby using a Lagrangianformulation.2If we let X be the Lagrangemultiplieron
the expectedutility constraint,,u, be the Lagrangemultiplieron the agent's first-period
effort constraint, and A^2(xl)be the multipliers associated with the second-period effort
constraints,the Lagrangianis
L[sl(xl,) SOXI, X2), a,, a0(X), X, tl, A'2(X,)]
= z {G,[xi - s,(x,)] + z GX-s2(x1, x2)]p2(x2la2(xI))}p1(x,la1)
+ X{ { U1[s1(x1)] + z U2[s2(x1, X2)]p2(X21a2(X1)) - V2[a2(x1)]}p1(x1la,) - V1(a1) - 0}
+ I{ Ul [Is (X1)] + z U2[s2(xI, X2)]p2(X21a2(X1)) - V2[a2(x1)]}p',(xIla,) - V,(a,)}
+ z 82(X,){X U2[s2(XI, x2)]p2(x2a2(x1l)) -V'[a2(X )] }

With these assumptions,we readilyobtain the followingproposition.

Proposition 1: Under the assumptionof an interiorsolution, the optimal sharingrules
will satisfy:
,- s1(x=)] A+ p1(x11a1) (6)
VI[s,(x,)I p,(x,la,)
G'2[X2- s2(x, x2)]A p'1(xIla1)+ 12(XI) P'2(X21a2(X1))
U'2[S2(XI X2)]
AI p1(x,la1) p1(xlla,) P2(X21a2(X1)) (7)

We can find the optimaleffortstrategyby differentiatingthe Lagrangianwith respect

to a, and a2(xI) and using (4) and (5) to get

E {G,[x, - s,(x,)] + EG2[s2(x1,x2), a2(xI)]}p'1(xulaI)

+ u,{ {U,[s,(xl)] + EH2[s2(x1, x2), a2(xI)]}p'(xulaI) - V'(a1)} = 0 (8)
G2[X2- s2(x,I x2)]p'2(x2la2(x1))

+ {2(xl) 1E U2[s2(x1,x2)Ip'"(x2la2(xI)) - V'[a2(x1)]} = 0. (9)

p1(x Ial)22
The terms multiplying, and A^2(xI)are the agent'ssecond-orderconditions on his
selectionof a, and a2(xI), respectively.Since these terms are assumedto be negative,we
have
Sign (,u,) = Sign [2 {G,[x, - sO(x,)] + EG2[s2(x1,x2), a2(x1)]}p',(x1la1)]
Sign [A'2(X1)] = Sign [E G2[x2- s2(x1, x2)]p'2(x21
a2(x1))].

2 See Grossman and Hart (1983) for a discussion of modeling issues and an examination of the existence
of a solution in a single-period agency model.

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446 / THE BELLJOURNALOF ECONOMICS

p'1(xllal)
I A
______
AX
Note that if we define X2(xI)= X + , I and82(X,) = we can wnte
p1(xlIa)nl L(l) -p,(xIa,)'
the second-periodsharingrule as:
s2(x1,X2)]= X2(X()+ Ap'2(X 2I 2(x1))
- (7a)
X2)]
U'2[S2(XI, P(X21a0(x))

Since a, is selectedand x, is observedbeforethe selectionof a2, the terms p1(xlIa)

p,(x,llal)
and ,u2(x,) are determinedbeforethe agent selects a2. This means that X2(x,) and ,u2(x,)
arefixedconstantsat the startof the secondperiod.Eachperiod'ssharingrulecan therefore
be expressedin the sameformas thatderivedin Holmstrom's(1979) single-periodanalysis.
In fact, all of the second-periodequations,(4), (7), and (9), are exactly the same
equationsas wouldbe derivedin a one-periodagencymodel correspondingto the second-
periodutility functionsof the principaland the agent and the second-periodproduction
function.The first-periodoutcome acts only as a parameterto determinewhich of the
(constrained)Paretoefficientone-periodsolutionsthe principaland the agent will arrive
at in the second period.
It is thereforeeasy to show, by using the same proof as in Holmstrom'sone-period
model, that the Lagrangemultiplieron the agent's second-periodeffort is positive for
each x, (the proofs of the remainingpropositionsare in the Appendix).
Proposition2: A2(x,) > 0 for each xl.
The interpretationof A2(x,) > 0 is that the principalwould preferthat the agentselect
p'(x,Ia,).
a higheramount of effortin the second period.If is an increasingfunction of x,
p,(xtIa,)
for each a, E A, the distributionpossessesthe monotone likelihoodratio property.For
those probabilitydistributionswhich satisfy the monotone likelihood ratio property,
A2 > 0 implies that the agent'ssecond-periodcompensationis an increasingfunction of
the second-periodcash flow. See Milgrom(1981) for a discussionof the applicationof
the monotone likelihoodratio propertyto severaleconomic models.
Let F,(H,) be the equation that describesthe second-bestPareto frontierin period
t whenthe utilityfunctionsand the productionfunctionin periodt are viewedin isolation.
We have
r7,(H,)= max E G,[x,- s,(x,)]p,(x,la,) (10)

subjectto
E U,[s,(x,)]p,(x,1a,)- V,(a,)> II,
a, E argmaxz Ut[s,(x,)]p,(x,la,)- V,(a,).

Becauseof the separabilityof the productionfunctionsand the utilityfunctionsovertime,

the equationwhich describesthis frontierdoes not depend on the first-periodcash flow
that is observed.Equations(4), (7a), and (9) indicatethat the welfareweight assignedto
the agent in the second periodis X2(xl)= X + ,Al
u (x a I) when the first-periodoutcome
p,(x, Ila,)
is x,. That is, when the first-periodoutcome is x,, the point on the F2 frontierthat is
chosen will be the one where the slope of the F2 frontieris -X2(x,). If we assume that
F2is a strictlyconcave functionof H2, there is a one-to-onecorrespondencebetweenthe
welfareweight assignedto the agent in the second period and the agent's (principal's)
expectedsecond-periodutility. The agent's(principal's)expectedsecond-periodutility is
an increasing(decreasing)function of the welfare weight assigned to the agent in the
second period. We shall use this to prove that the Lagrangemultiplieron first-period
effortis also positive.

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 LAMBERT / 447

Proposition3: ,u > 0.
This propositionimpliesthatthe incentiveproblemassociatedwith the agent'schoice
of first-periodeffortis not eliminated.Therefore,the principal'sabilityto use both first-
and second-periodrewardsand penaltiesdoes not lead to the "full ex post settling up"
phenomenon discussedby Fama (1980). Using equation (7), ,u > 0 implies that the
second-periodsharingrule willdependon the first-periodoutcome.In addition,ifp,(x,Ia,)
satisfiesthe monotone likelihoodratio property,it is easy to show that
s, is an increasingfunctionof xl,
EH2[s2(x1, x2), a2(x1)]is an increasingfunction of xl, and
EG2[s2(xI, x2), a2(x1)]is a decreasingfunction of x,.
Note that the contractensuresthat the second-periodincentivesreinforcethe first-period
incentivesin motivatingthe agent'sfirst-periodeffort.In otherwords,both his first-period
compensationand his expectedsecond-periodutilityare increasingfunctionsof the first-
period cash flow.
It is relativelyeasyto extendthis modelto morethantwo periods.Usinga formulation
analogousto problem(1), let Xbe the Lagrangemultiplieron the constraintthat the agent
receiveat least 0 over the T-periodhorizon. Let u,(X,_,)be the Lagrangemultiplieron
the agent's choice of effort in period t when the prior sequence of cash flows is
x,-I = (xi, ..., x,_,). It is easy to show that the optimal sharing rule in period t will
satisfy(assumingan interiorsolution):
G'[x,- S,(x-1, xi)] ')= a,(x-i) + M(X( )

where

A,x,_I-) = A + M(1)p'j(xjIaj(xj-1))
Aj(xj-l) IjXa(',
pi(x11a1(x1,))'
and

H pj(xjlaj(xj-,))
j=,
We can also show that u,(X,_,) > 0 for all X,-l. Just as in the two-period analysis, the
principaluses both current-periodand future-periodincentives to motivate the agent's
effortin each period.

4. Interpretation of results
N In a single-period model, the agency problem exists because the uncertainty prevents
the principalfrom using the cash flow to determineunambiguouslythe agent's action.
Holmstrom(1979) suggeststhat "when the same situation repeatsitself over time, the
effectsof uncertaintytend to be reducedand dysfunctionalbehavioris more accurately
revealed,thus alleviatingthe problem of moral hazard."Under these conditions, if the
agentselectsthe first-bestlevel of effortin each period,the cash flow will be independent
and identicallydistributedover time. As the number of periodsincreases,the variance
of the agent'saverageoutput, if he selectsthe first-bestlevel of effortin each period,gets
smaller.Note that for this diversificationeffectto occur, it is necessarythat the principal
evaluatethe agent'seffortover the entirehistoryof his employment,ratherthan evaluate
each period'sperformanceseparately.
Radner(1980) and Rubinsteinand Yaari(1980) considerthe extremecase in which
therearean infinitenumberof observations.They show that the principalcan eventually

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448 / THE BELL JOURNAL OF ECONOMICS

detect any systematicshirkingon the partof the agent by comparingthe agent'saverage

outputwith what would be expectedif the agent had been selectingthe first-bestlevel of
effortin each period.They analyzea simple dichotomouscontractin which the agent is
offeredthe first-bestsharingrule in period t if his averageperformancein periods one
throught - 1 has been "acceptable,"and a penaltycontractif his performancehas been
unacceptable.3Since they also assume that the agent does not discount his utility, the
futurepenaltiesthat can be imposed upon detection are sufficientto preventthe agent
from shirking.In these cases, then, the uncertaintycan be completely diversifiedaway
and the incentiveproblemcan be completelyeliminated.
In a finite horizon model, the uncertaintycan be partially,but not completely,di-
versifiedaway. The optimal contract is thereforemore complicatedthan those derived
on the infinitehorizonmodels.For example,supposethatthe agentis evaluatedaccording
to his averageperformance.If the agentis "lucky"in the firstperiod,x, will be high. The
agent can then "take it easy" in the second period without hurtingx, + x2 excessively.
The agentthereforehas incentiveto adjusthis effortovertime as a functionof his previous
performance.Becauseof this phenomenon,the optimal contractwill not, in general,be
a simple function of the agent'saverageperformance.
Of course,this type of behavioralso arisesin an infiniteperiodmodel. However,the
agent can only do it a finite numberof times before his behavioris detected. Since the
behaviorover a finite numberof periodshas a negligibleeffecton his averageutilityover
the infinitehorizon,this type of behaviorcan be "ignored"in the papersof Radnerand
of Rubinsteinand Yaari. In a finite horizon model, however,each period is important.
Therefore,the agent's incentive to manipulatehis effort over time in response to his
previousperformanceplaysa more significantrole in derivingthe optimal contract.4We
should point out that even the optimal contractdoes not eliminatethe agent'sincentive
to engagein this type of behavior.
The diversificationeffectsuggeststhat the more periodsthe agencyrelationshiplasts,
the more the incentiveproblemis alleviated.In fact, we can show that there is value to
extendingthe length of the contract.'Considerthe differencein the principal'sexpected
utility when he uses the optimal long-termcontractcomparedwith a sequence of inde-
pendentcontracts.This differenceis an increasingfunction of the length of the contract.
Let I" representthe second-bestPareto frontierwhen periodst throughT are con-
sidered together(throughprecommitmentto a long-termcontract). In the two-period
analysis,we showed that it is optimal to make the second-period(sharingrule, action)
pairdependon the first-periodcash flow.This impliesthat the second-bestParetofrontier
when the two periodsare consideredtogetheris above the sum of the two frontierswhen
they are viewed separately.Formally,we have H = HI + H2 implies
F (H) > rF(H,) + F2(H2).

T T7
Let Hf =, Hi. We thereforehave Hf = H, + H,+,. In a manneranalogousto the two-

3 They also demonstratethat the principalcan providethe agentwith a marginof safetyto give him the
benefitof the doubt in case he has been selectingthe correctactionsbut has been experiencingbad luck.
4 To see this, supposethe agentis requiredto selectthe same amountof effortin each period.In this case,
it is optimalto evaluatethe agenton the basisof his averageperformanceif the likelihoodfunctionis a linear
functionof x,.
S If the productionfunctionvariesstochastically over time, theremay be some circumstancesunderwhich
it is optimal to abandonthe firm or hire a different"type"of agent, one with a differentset of skills, etc.
Similarly,if the agent'stastes or skills vary stochasticallyover time, situationsmay arise under which it is
optimalfor the agent to leave the firm.These considerationswill tend to counteractthe value of a long-term
contractwhich binds the agentto the firm.

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 LAMBERT/ 449

period analysis, we can show that F/(H/)> F1(H1)+ F;+i(H/+i) MovingF1(H1)to the left-
hand side and subtracting I F1(H1)from both sides yield
) =1+ 1
7 7

FJ(H) )-E rF(H1) > 7+ (H,+) - 1

Fj(H1).
j=t j=t+I

That is, the distancebetweenthe second-bestParetofrontierwhen all of the periodsare

consideredtogetherand the sum of the second-bestfrontierswhen each period is con-
sideredseparatelyincreasesas the numberof periodsundercontractincreases.Of course,
this does not imply that the incentive problemis completelyeliminatedas the number
of periodsapproachesinfinity.
The diversificationeffect coupled with the fact that the agent guaranteesto remain
with the firm might suggestthat the principalwait until the final period to rewardor
penalizethe agent. In the last period,the principalhas the most informationconcerning
)
the agent's overall performance,1 4,(X,-,) t . ) . Why not make the contract
1= p,(xllat(xi- ,))
satisfy equation (11) when t = T, but allow for optimal risk sharing, G,[x, - s,(x,)]
= XU,[x, - s,(x,)], for t < T?
The reason that this is not optimal is that the agent would prefer,all other things
equal, a smooth consumptionstream over time. Unfortunately,the first-periodsharing
rule cannot make use of the informationconveyedby the second-periodoutcome. How-
ever, the first-periodcomponent of the agent'soverallperformanceis availablewhen the
agent is to be paid in the firstperiod.The optimal employmentcontractspecifiesthat in
each period,all of the informationthat is availableat that time concerningthe agent's
overall performancewill be used in determiningwhat his compensationin that period
will be. Note that the sharingrules are constructedso that
E[G',[x(-js(x,)I] G
E[LJAX2-SX(I, X2)]
U'lIsI(XI)] U'2[S2(XI, X2)]
and for each xi
-
-
G[x s(x)]I 1 G'X2 s2(xI, x2)] 1 p(xll)
LU'1[s1(x1)I i X2)]
U'2AS2(X1, Xi "p1(x1ia1Y
In other words, the sharingrules are constructedso that the ratio of the expected
marginalutilitiesof the principaland the agent, both unconditionaland conditionalon
the occurrenceof each xl, is equal acrossperiods.This suggeststhat anotherpropertyof
the optimal long-termcontractis that it smooths the agent'sincome over time. Another
interpretationof this is that the principalspreadsthe riskof the first-periodoutcome over
as many periodsas possible.By usingthe sharingrulesto smooth the agent'sincome, the
principalcan give the agent a lower expectedpayment in each period and still meet the
agent'sminimum utility constraint.

5. No commitment
* To this point we have assumed that both the principaland the agent precommitto
a long-termcontract.In many cases it is not feasibleor legal for the agent to commit to
remainingwith the firm. If the agent findsa more attractiveemploymentopportunityin
a later period, he is free to leave the firm to take it. In this section we incorporatethis
into the analysisby relaxingthe assumptionthat the agent is committed to remaining
with the firm for both periods.
The principalis assumedto be committedto any two-periodcontractthat he offers;
however,the agent has the option to leave the firm after the firstperiod. To model this

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450 / THE BELLJOURNALOF ECONOMICS

situationwe must make an assumptionregardingthe utility that the agent can achieve
in the second period.For convenience,we assumethat 02, the amount of utility that the
agent can obtain, is independentof xl.6 The agent'sthreat of leaving places additional
constraintson a feasible two-period contract. In addition to satisfying H(s, a) 2 0
= 01 + 02, a feasibletwo-periodcontractmust also satisfyE[H2[s2(x1,x2), a2(x1)11x11
2 02
for all xl.
We can replicatethe analysis in Section 3 to show that the optimal contract will
satisfy equations (6) and (7a), where now X2(xI) = max X + 41 P'l(l I) X2), and
-A2 is the slope of the 12 frontierat the point wherethe agent'sexpectedsecond-period
utilityis 02. Recallthat the agent'sexpectedsecond-periodutilityis an increasingfunction
of X2(xI). Essentially,the external labor market provides the agent with insuranceby
limitingthe amount that the principalcan penalizethe agent for a bad first-periodper-
formance.No matterhow bad his first-periodperformancehas been, the agent is guar-
anteedan expectedutility of at least 02 in the second period. The principalmust match
this to keep the agent from leaving.7
Becausethe penaltiesthat can be imposed upon the agent have been limited, it will
generallybe the case that the principalcannot motivate the agent'sfirst-periodeffortso
efficientlyas he could when the agent precommittedto a two-periodcontract.This will
lead to a welfareloss. However, note that it is still optimal to rewardthe agent in the
second period for a good first-periodperformance.Therefore,the agent'ssecond-period
compensationwill still depend on both his first-periodand second-periodperformance.
To lose the dependenceof s2 on xl, it is necessarythat neitherthe principalnor the
agent precommitto a long-termcontract,and that the externallabor marketnot adjust
the utilityvalue of the agent'soutsideemploymentopportunitiesas a functionof his first-
period performance.Under these circumstances,the multiperiodprincipal-agentrela-
tionship decomposesinto a sequenceof one-periodgames. In each period the principal
and the agent act exactly as they would if that were the only period in the game. The
agentwill receivean expectedutilityof 02 in the second periodregardlessof what happens
in the firstperiod.

6. Concluding remarks
* In a dynamic model with incentiveproblemswe have demonstratedthat the agent's
second-periodcompensationwill dependon his first-periodperformance.This allowsthe
principalto diversifyaway some of the uncertaintysurroundingthe agent's actions. In
addition,this allows the principalto smooth the agent'sincome over time by spreading
the riskof the first-periodoutcome over both periods.If a capitalmarketfor transferring
wealthovertime exists,the principaland the agentmay be ableto deferthis latterfunction
of the long-termcontractto the capital market.It seems difficultto fully incorporatea
capitalmarketinto the analysis.The primaryproblemis that the agent'seffortstrategy
will not be separablefromhis savingsdecisions.Forexample,the agent'schoice of second-
period effortwill be a decreasingfunction of the amount he has saved, ceteris paribus.
In this case, the cross partialderivativesbetween effort and saving become important,
and this considerablycomplicatesthe signingof the Lagrangemultiplierson the agent's
effort.
There are many interestingaspectsof multiperiodagency relationshipswhich have
not been addressedhere.We consideredsituationsin which the productionfunctionsare

6
The analysisalso holds if 02 is a randomvariablewhose distributionis independentof xi.
7Alternatively, supposethe agent leaves the firm and receivesan expectedutility of
02 elsewhere.The
principalmust then hire an equivalentagentand providethe new agentwith an expectedutilityof at least82.

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 LAMBERT / 451

separableover time and the statesof natureare independentlydistributedover time. One

obviousareafor futureworkis studyingsituationsin whichthe periodsareinterdependent.
For example, there could be some uncertaintyconcerningthe agent's skill or the
form of the productionfunction. Each period'sproductionwould then provide infor-
mationaboutthe agent'sactions,his skill,and the formof the productionfunction.Harris
and Holmstrom(1982) study a multiperiodmodel in which the agent'sskill is unknown
to both himselfand all his potentialemployers,but thereis no moralhazardon his effort.
In their model, each period's output provides additional information concerning the
agent'sskill.Harrisand Holmstromderivepropertiesconcerningthe way the agent'swage
will be updatedover time. It would be interestingto integratethe problem that they
addresswith the moral hazardproblemstudied here.
Anotherformof interdependencebetweenthe periodsthatcouldbe studiedis whether
the actions have multiperiodeffects.For example, the agent may be responsiblefor se-
lecting investmentactions in addition to the productiveeffort studied here. Increasing
the investmentwould decreasecurrentproduction,but increasefutureproduction.The
problem of short-runvs. long-run optimizationcould then be addressedin an agency
setting. The optimal compensationscheme would have to motivate the agent to work
hard in each periodand to select the properlevel of investment.

Appendix
* Proofsof Propositions2 and 3 follow.
Proofof Proposition2: Since the left-handside of (6) is greaterthan zero, so is the right-
hand side. This implies that X2(xI) is greaterthan zero. Let S2f(X2) be the sharingrule
which satisfiesG'[x2 - s2f(x2)] = X2(X,)U'2[S2f(X2)].
By using the same proof as in Holmstrom(1979), ,A2(x0)< 0 implies
- s2(x, x2)]p'2(x2la2(x1))
Z G2[X2 > 0,
2 Z G2[x2- s2f(x2Dp'2(x2Ia2(x1))

where the last inequalityfollows by stochasticdominance (and because S2f is increasing

in x2). However,by using equation(9), z G2[x2- s2(xI, x2)]p'2(x2ja2(x1))> 0 contradicts
A2(xI) < 0. Q.E.D.
Proofof Proposition3:
LemmaAl: If,u, < 0, then z G,[x,- s(x1)]p'1(x11a)> 0.
Proofof Lemma Al: The proof is the same as the proof of Proposition2. Let s1f(x1)be
the sharingrule which satisfiesG'1[xl- slf(xl)] = XU'4[sIf(x1)].
Assuming that AI < 0, we derive that
z G,[x,- s(xI)]p'1(x1IaI) ?2 G,[x, - s1f(x1)]p',(x1IaI)> 0,
where the last inequality follows by stochastic dominance (and s,f is increasing in
xI). Q.E.D.
LemmaA2: If,u, < 0, then z [EG2[s2(x,x2), a2(xI)]]p'1(xI1aI)2 0.
Proofof LemmaA2: Assuming F2(H2)is a strictlyconcave functionof H2, the principal's
expectedsecond-periodutility is a strictlydecreasingfunction of the welfareweight as-
signedto the agent in the second period.Accordingto equation(7), the agent is assigned
a welfareweight of X2(xI) = X + Al p'1(x'a) in the second period when the firstperiod
p1(x1Ilal)
outcome is xl. Let F2x be the principal'sexpected utility at the point on the F2 frontier
wherethe slope is -X. The strictconcavity of F2 implies that F2, is unique.

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 452 / THE BELLJOURNALOF ECONOMICS

Assume that Let X, = > 0}. For all x, E X, we have

,gl < 0. {x,lp'(xjlaj)
X + A, p,(x1'a) < X. We thereforehave EG2[s2(xI, x2), a2(x1)]?> F2 for all xi E X+.
I
pl(x,llal)
Multiplying both sides by p'1(xi a,) > 0 gives
EGA[SA(XI x2), a2(X1AP 1(x,la,) 2 r2X P' (xI Ila).

Similarly,for all x, E X-, we have EGAs2(x1, x2), a2(x1)] < r2x. Multiplyingboth
sides by p'1(xla,) < 0 gives
EGA[S(XI, x2), a2(X,)]P'(x,|aj) 2 1'2XP'1(xj |aj)

Summingover all x, implies

z EG2[s2(x, x2) a2(x1)]p'(x,la1) 2 z I2Xpt(xIla,) = 0.
The last equalityis because r2Xis independentof xi. Q.E.D.
Combining these two lemmas, ,u, < 0 implies

{G,G[xl
z - s,(xj)] + EGAs2(x1, x2)a2(x1)] > 0.
}?P'(xjla1)
which contradictsAl < 0 (by using equation(8)). Q.E.D.

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