On the Role of Boundary Solutions in Principal-Agent Problems with Effort Costs Depending on Mean Returns

Hellwig, Martin

URL:	http://finance.bi.no/~finance/seminar/Hellwig.pdf
Additional URL:	http://finance-old.bi.no/~finance/seminar/Hellwig....
Document Type:	Working paper
Year of publication:	2001
The title of a journal, publication series:	Rationalitätskonzepte, Entscheidungsverhalten und ökonomische Modellierung
Volume:	01-51
Place of publication:	Mannheim
Publication language:	English
Institution:	School of Law and Economics > VWL, Wirtschaftstheorie (Kübler -2011)
MADOC publication series:	Sonderforschungsbereich 504 > Rationalitätskonzepte, Entscheidungsverhalten und ökonomische Modellierung (Laufzeit 1997 - 2008)
Subject:	330 Economics
Abstract:	The paper takes issue with the suggestion of Holmström and Milgrom (1987) that optimal incentive schemes in Brownian-motion models of principal-agent relations with effort costs depending on mean returns are linear in cumulative total returns. In such models, if actions are restricted to compact sets, boundary actions are optimal and typically can be implemented with lower risk premia than are implied by linear schemes. The paper characterizes optimal incentive schemes for discrete-time approximations as well as the Brownian-motion model itself. Solutions for discrete-time approximations - and the continuous-time limits of such solutions - always lie on the boundary.