Dynamic Correlation as an Incentive Device

Abstract

I introduce dynamic correlation as an incentive instrument to address moral hazard. A firm mediates interactions between a long-lived worker and short-lived clients. I show that optimal mediation induces a nonstationary correlated information structure that transitions from private to public communication, consistent with the empirical shift from personalized to standardized communication in organizations. By using private communication to correlate continuations, the firm relaxes otherwise binding incentive constraints and strengthens effort incentives. Mediation expands the Pareto frontier and generates a distributional conflict between the worker and the average client, and is Pareto-improving if and only if the worker is sufficiently patient.