MICRO/THEORY: Optimal Contracting with Many Agents; Professor Ernst-Ludwig von Thadden (University of Mannheim)

Abstract

The paper takes a mechanism design approach to dynamic capital allocation and risk-sharing between a planner (the principal) and decentralized asset managers (the agents). Incentive-compatibility implies that managers with better idiosyncratic performance get larger fees, capital, and continuation utilities. This generates an endogenous distribution of utilities across managers, which is a state variable of the optimal control problem of the principal. With a continuum of agents, this gives rise to a Bellman equation in an infinite-dimensional space, which we solve with mean-field techniques. With CRRA utilities, optimal compensation is proportional to assets-under-management and costly exposure to idiosyncratic risk lowers risky investment.