A Class of Explicit optimal contracts in the face of shutdown

TL;DR

This paper develops explicit optimal contracts in a dynamic principal-agent model considering pandemic-related shutdown risks and potential early termination, extending classical models to include default risk and risk mitigation strategies.

Contribution

It introduces a new explicit characterization of optimal contracts under shutdown risk and early termination, incorporating linear prevention mechanisms and risk mitigation options.

Findings

Optimal contracts are linear, combining output sharing and prevention proportional to contract duration.

Default risk influences the structure of the optimal wage and agent's actions.

Adding risk mitigation options affects the contract's form and optimality.

Abstract

What type of delegation contract should be offered when facing a risk of the magnitude of the pandemic we are currently experiencing and how does the likelihood of an exogenous early termination of the relationship modify the terms of a full-commitment contract? We study these questions by considering a dynamic principal-agent model that naturally extends the classical Holmstr{\"o}m-Milgrom setting to include a risk of default whose origin is independent of the inherent agency problem. We obtain an explicit characterization of the optimal wage along with the optimal action provided by the agent. The optimal contract is linear by offering both a fixed share of the output which is similar to the standard shutdown-free Holmstr{\"o}m-Milgrom model and a linear prevention mechanism that is proportional to the random lifetime of the contract. We then tweak the model to add a possibility for risk mitigation through investment and study its optimality.