Progressive Learning

Abstract

We study a dynamic principal-agent relationship with adverse selection and limited commitment. We show that when the relationship is subject to productivity shocks, the principal may be able to improve her value over time by progressively learning the agent’s private information. She may even achieve her first best payoff in the long-run. Moreover, the relationship can exhibit path dependence, with early shock realizations determining the principal’s long-run value. These findings contrast sharply with the results of the ratchet effect literature in which the principal persistently obtains low payoffs, giving up substantial informational rents to the agent.