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Abstract:
This paper develops a methodology to solve dynamic principal-agent problems in which the agent features present-biased time preferences and naive beliefs. There are three insights. First, the problem has a recursive representation using the agent's perceived continuation value as a state variable (i.e., the remaining value the agent (wrongly) anticipates getting from the contract). Second, incentive compatibility corresponds to a volatility constraint on the agent's perceived continuation value. Finally, due to the agent's naivete, a perceived action constraint needs to be satisfied. This constraint is accommodated by linking the agent's perceived effort policy and the volatility of his perceived continuation value. Novel economic insights regarding optimal time-varying incentives and the term-structure of compensation are also explored
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William Bruce-Doig