Commitment contracts

Abstract

We analyze a consumption-saving problem with unverifiable savings in which time-inconsistent preferences generate demand for commitment, but uncertainty about future consumption needs generates demand for flexibility. We characterize in a standard contracting framework the circumstances under which this combination is possible, in the sense that a commitment contract exists that implements the desired state-contingent consumption plan, thus offering both commitment and flexibility. Although we do not impose any restrictions on the set of possible contracts, we show that commitment contracts- when they exist- take the familiar form of a long-term savings account that permits some early withdrawals without a penalty, but imposes a penalty on any further withdrawals. With such an account, an individual is deterred from making premature withdrawals by the prospect of future selves withdrawing even more at the penalty rate. The key insight is that time-inconsistent preferences turn a single individual into a collection of selves with different preferences but the same information, effectively turning a single-agent contracting problem into a multi-agent mechanism design problem.