HEC Research Papers Series,
HEC Paris

Abstract: This paper analyzes dynamic capital allocation and risk sharing between a principal and many agents, who privately observe their output. The state variables of the mechanism design problem are aggregate capital and the distribution of continuation utilities across agents. This gives rise to a Bellman equation in an infinite dimensional space, which we solve with mean-field techniques. We fully characterize the optimal mechanism and show that the level of risk agents must be exposed to for incentive reasons is decreasing in their initial reservation utility. We extend classical welfare theorems by showing that any incentive-constrained optimal allocation can be implemented as an equilibrium allocation, with appropriate transfers and wealth taxation by the principal.

Keywords: Dynamic contract theory; mechanism design; large economies; allocative efficiency; incentive-compatibility; mean-field games; implementation

JEL-codes: C61; D82; D86; D92; E22

34 pages, April 11, 2024

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