The Dynamics of Bargaining Power in a Principal-Agent Model

Abstract

We propose a dynamic principal-agent model where the agent's bargaining power is the state variable and a law of motion that governs their bargaining power's behavior. Furthermore, we demonstrate the equivalence between our formulation of the dynamic principal-agent relationship and the standard formulation in which the state variable is the agent's reservation utility. Also, we propose and implement a numerical strategy to approximate our model's optimal contract and corroborate our equivalence results. Our numerical results indicate that agents with the same relative risk aversion might show different paths of their bargaining powers, and that more powerful the incentives ensue higher variability in the agent's salary. Finally, we explore the relationship between firm performance and CEO compensation by proposing an empirical equation, that is brought about from our law of motion and numerical results, to identify CEOs’ bargaining power and use model-generated data to validate it. JEL Codes: C61, D86.