“Dynamic Contracting with Limited Commitment and the Ratchet Effect”

Abstract

We study dynamic contracting with adverse selection and limited commitment. A Örm (the principal) and a worker (the agent) interact for potentially inÖnitely many periods. The worker is privately informed about his productivity and the Örm can only commit to short-term contracts. The ratchet e§ect is in place since the Örm has the incentive to change the terms of trade and o§er more demanding contracts when it learns that the worker is highly productive. As the parties become arbitrarily patient, the equilibrium allocation takes one of two forms. If the prior probability of the worker being productive is low, the Örm o§ers a pooling contract and no information is ever revealed. In contrast, if this prior probability is high, the Örm Öres the unproductive worker at the very beginning of the relationship.