Optimal stationary contract with two-sided imperfect enforcement and persistent adverse selection

- The optimal stationary contract in an infinitely repeated relationship is proposed.
- The contract is made of two distinct pieces.
- For the most efficient types of the agent, the contract entails bunching.
- For less efficient types, the contract exhibits downward output distortions.
- Distortions are set below the Baron-Myerson level.

We consider an infinitely-repeated principal-agent relationship run with stationary contracts. The agent has private information on his persistent cost parameter and, under limited enforcement, both parties can breach the contract. The optimal stationary contract with limited enforcement is made of two distinct pieces. For the most efficient types of the agent, the contract entails bunching with a fixed payment and a fixed output. For less efficient types, the contract exhibits downward output distortions below the Baron-Myerson level that would have been achieved had enforcement been costless.