Avidit Acharya (Stanford University)

“Improving the Relationship: A Principal-Agent Model of Progressive Learning and Path Dependence”

Abstract

We study a dynamic principal-agent relationship with adverse selection and limited commitment. We show that when the relationship is subject to time-varying productivity shocks, the principal may be able to improve her value over time by gradually learning the agent’s private information. Moreover, the relationship may display path-dependence, with early realizations of the shock determining the principal’s long-run value. These findings contrast sharply with the results of the ratchet effect literature in which the principal persistently contents herself with low values, giving up substantial informational rents to the agent.