Ambiguity in dynamic contracts
I study a long term principal-agent model in which the principal is ambiguity averse about the agent’s effort cost, which is subject to shocks. The robust optimal contract features two regions. After sufficiently high performance, the agent receives excessive benefits compared to the contract without ambiguity, while after low performance, he is undercompensated. Ambiguity also causes a disconnect between the current effort cost and the strength of incentives, and the agent receives excessively strong incentives no matter whether he is over- or undercompensated. Under ambiguity, the agent’s true effort cost does not need to equal the worst case. I explicitly solve the agent’s problem for this case, and show that the possibility of firing is detrimental to the agent’s incentives. I study several extensions concerning the timing structure and the nature of the principal’s ambiguity aversion.