Some Notes on Dynamic Adverse Selection

This key tension in this set of topics centers around the role of commitment in longterm contracting. Previously, we assumed full commitment power on the part of the Principal in setting all aspects of a contract. In a dynamic setting, the ful…llment of the early stages of a contract provides information to the Principal about the agent’s type. Naturally, the Principal will be tempted to act on this information, and this temptation can lead to incentives to renegotiate the initial contract. Of course, the agent will anticipate these incentives as well and this will then a¤ect the incentive constraints facing the agent at the initial contracting stage. This set of notes explores these issues. Outline of paper: First, we highlight the central tension in an ultra-simple application of dynamic commitment. Next, we compute the optimal dynamic contract under full commitment. Finally, we examine how the optimal contract changes when the assumption of perfect commitment is relaxed. Along the way, we introduce a slight extension of the revelation principle, the so-called renegotiation-proofness principle, to studying optimal contracts with imperfect commitment.