Learning, belief manipulation and optimal relationship termination

We study a dynamic agency problem in which a principal and an agent interact on a project repeatedly with the agent's ability initially unknown to both players. Because an incompetent agent generates successes less frequently and thereby needs to be rewarded more generously for his successes, the agent has attempts to “play dumb” by shirking deliberately. We show that the principal can incentivize the agent by resorting to a combination of wage payments and relationship termination. In equilibrium, relationship termination is introduced in the contracts only when the players’ assessment about the agent's ability is above a threshold. As a result, the dynamic agency cost presents a non-monotonic relationship with the agent's ability.