Dynamic managerial compensation: A variational approach

We study the optimal dynamics of incentives for a manager whose ability to generate cash flows changes stochastically with time and is his private information. We show that distortions (aka, wedges) under optimal contracts may either increase or decrease over time. In particular, when the manager's risk aversion and ability persistence are small, distortions decrease, on average, over time. For sufficiently high degrees of risk aversion and ability persistence, instead, distortions increase, on average, with tenure. Our results follow from a novel variational approach that permits us to tackle directly the “full program,” thus bypassing some of the difficulties of the “first-order approach” encountered in the dynamic mechanism design literature.