Papers

**Dynamic Moral Hazard with Persistent States**This paper studies a model of principal-agent problem in a partially persistent environment. The costly unobservable action of the agent produces a good outcome with some probability, and the probability of good outcome corresponds to the state. The states are unobservable and follow an irreducible Markov chain with positive persistence. The paper finds that an informational rent arises in this environment. The principal can, however, reduce the rent by taking an inefficient outside option in some periods. In some situations, the second best contract resembles a tenure system: the agent is paid nothing during the probationary period after which the principal implements the first best action in every period. In some circumstances, the second best contract becomes stationary after the agent is tenured. The paper provides a recursive formulation for complete characterization of the second best. For discount factors close to one, the principal can approximate his first best payoff.

**Relational Contracts in a Persistent Environment**This paper studies relational contracts with partially persistent states, where the distribution of the state depends on the previous state. When the states are observable, with both exogenous and endogenous states, the optimal contract can be stationary, and an effort schedule can be implemented with a stationary contract if and only if it satisfies the IC constraint and the dynamic enforcement constraint. The paper shows how the joint surplus in the second best varies with the state. The paper then applies the results to study implications for markets where the principal and the agent can be matched with new partners.