Breakthroughs, Deadlines and Severance: Contracting for Multistage Projects

Abstract

We study the optimal provision of incentives in a dynamic multistage agency setting. Specifically, there is a project, whose benefits are realized only after multiple sequential breakthroughs. The project requires funding from the principal and is operated by an agent who is protected by limited liability and can divert cash ows for private benefit. The nature of progress plays an important role in the optimal incentive scheme. When breakthroughs are tangible (i.e., observable and contractible), they serve as a useful monitoring device, and the principal controls incentives through a sequence of deadlines and a reward scheme that decreases over time; a breakthrough in one stage extends the amount of time the agent has to complete the next stage. When breakthroughs are intangible (i.e., privately observed by the agent), the principal must provide incentives for truthful self-reported progress. Our primary questions are whether, to what extent, and how this type of communication can be used in a meaningful way.