Contracting with discretionary bonuses

TL;DR

This paper models a continuous-time principal-agent contract with discretionary, sequential bonuses, analyzing how timing and incentives affect optimal schemes through numerical simulations.

Contribution

It introduces a mixed control and stopping framework for analyzing dynamic bonus payments and highlights conditions for sign-on bonuses.

Findings

Sign-on bonuses can be optimal in certain environments.

Timing and impatience influence bonus structure and principal's value.

Numerical simulations reveal how bonus frequency affects incentives.

Abstract

We study a continuous time contracting model in which a principal hires a risk averse agent to manage a project over a finite horizon and provides sequential payments whose timing is endogenously determined. The resulting nonzero-sum interaction between the principal and the agent is reformulated as a mixed control and stopping problem. Using numerical simulations, we investigate how factors such as the relative impatience of the parties and the number of bonus payments influence the principal's value and the structure of the optimal bonus payment scheme. A notable finding is that, in some contractual environments, the principal optimally offers a sign-on bonus to front-load incentives.