*This page is referenced in [[BPP Field Exam Papers]]
==Reference(s)==
Holmstrom B., (1999) "Managerial Incentive Problems: A Dynamic Perspective," Review of Economic Studies, 66(1): 169-182 [http://www.edegan.com/pdfs/Holmstrom%20(1999)%20-%20Managerial%20Incentive%20Problems.pdf pdf]
==Abstract==
The paper studies how a person's concern for a future career may influence his or her incen- tives incentives to put in effort or make decisions on the job. In the model, the person's productive abilities are revealed over time through observations of performance. There are no explicit output-contin- gent contingent contracts, but since the wage in each period is based on expected output and expected output depends on assessed ability, an "implicit contract" links today's performance to future wages. An incentive problem arises from the person's ability and desire to influence the learning process, and therefore the wage process, by taking unobserved actions that affect today's performance. The fundamental incongruity in preferences is between the individual's concern for human capital returns and the firm's concern for financial returns. The two need be only weakly related. It is shown that career motives can be beneficial as well as detrimental, depending on how well the two kinds of capital returns are aligned.
==The Holmstrom Career Concerns Model==
*A competitive labour market
Key InsightsHow to solve:
*Competitive labour market bids up to the expected output that a manager will provide
*In equilibrium the beliefs of the labour market are correct
*Use the conditional normal distribution equation to solve the Bayesian updating
Key Resultsresults:
*The labour market acts as an indirect mechanism for linking past-performance to wages
*Career concerns generally do not provide first best incentives, they over and/or under shoot
Wages are paid in advance so in the second period the agent exerts no effort. In equilbrium <math>a_{1}^{*}\,</math> is correctly anticipated.
The market observes <math>z_{1}\equiv \eta +\varepsilon _{1}=y_{1}-a_{1}^{*}\,</math> and uses this to form its conditional expectation <math>\mathbb{E}[\eta|z_{1}]\,</math>. Given the assumption of normality we can use the [[Conditional Normal Distribution | conditional normal equation]] to give:
As <math>g^{\prime }(a_{1}^{*}) < 1\,</math>, it must be the case that <math>a_{1}^{*} < a^{FB}\,</math>. Likewise if the agent lives for <math>T\,</math> periods then <math>a_{T}^{*} = 0\,</math>, so effort declines from the first period onwards, but some effort is exerted in the first period and it is increasing in <math>\beta\,</math> (as the future becomes more important). The manager exerts a higher effort in the first period because he knows that this be attributed to ability in the second period and so result in a higher wage, but in a rational expectations equilibrium this effort is anticipated by the market and the manager is forced into making it because otherwise the market will downgrade his ability.
Noting that <math>h_{t} \rightarrow \infty\,</math> which implies that as time progresses the market gets an ever better estimate of the manager's ability and so the manager's wages <math>a_{t}^{*}(y^{t-1}) \rightarrow 0\,</math> (see below).
where <math>\alpha _{s}\equiv \frac{h_{\varepsilon }}{h_{s}}\,</math>
So early in the manager's career he will work hard (though possibly still below first best, depending on the parameterization), and this work 'ethic' will tend to zero as his career progresses.
===Infinite Horizon with varying ability===
For incentives not to disappear there must always be some uncertainty about the manager's ability, so now suppose:
:<math>\eta _{t+1}=\eta _{t}+\delta _{t}\,</math>
where <math>\delta _{t}\sim N(0,\frac{1}{h_{\delta}})\,</math>
So must conclude that the variance tends to a steady state and not to zero. This in turn leads to steady state effort, which we can solve for by equating the marginal benefit to the marginal cost of a change:
Which in turn leads to Holmstrom's proposition 1 that the stationary effort is <math>a^{*}\leq a^{FB}\,</math> and only equal to first best if <math>\beta =1,\,\frac{1}{h_{\varepsilon }}>0\,</math>, and <math>\frac{1}{h_{\delta }}>0\,</math>