Designing Incentive-Alignment Contracts in a Principal-Agent Setting in the Presence of Real Options

Abstract

We develop a model of incentive compensation for optimal upgrades supplied by an outsourced Information Technology department. We first consider the problem when the rate of technological development is certain and there are no information asymmetries between the parties. We extend this to allow private information between the principal and an agent acting as an external supplier of information technology upgrades. Based on the model in these simple circumstances, we then model uncertain technological improvements, where improvements evolve as Geometric Brownian motion, and there is benefit to flexibility in the timing of the upgrade. We are aware of contracts, known as "evergreen upgrades", where a principal pays for upgrades at specified intervals. We find little support for such a contract in our model, and the loss of flexibility in the timing of upgrades is puzzling. The Stern-Stewart problem encourages us to consider just such instances, where contracts limit flexibility that it may in the interest of both parties to retain.