Competitive Markets Without Commitment

In the presence of a time-inconsistency problem with optimal agency contracts, the authors show that competitive markets implement allocations that Pareto dominate those achieved by a benevolent planner, they induce strictly more effort, and they sometimes make the commitment problem disappear entirely. In particular, they analyze a model with moral hazard and two-sided lack of commitment. After agents have chosen a hidden effort and the need to provide incentives has vanished, firms can modify their contracts and agents can switch firms. As long as the ex-post market outcome satisfies a weak notion of competitiveness and sufficiently separates individuals who choose different effort levels, the market allocation is Pareto superior to a social planner's allocation.