Dynamic agency and investment theory with model ambiguity

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This paper examines how ambiguity in the production process and exogenous shocks affect contractual outcomes by incorporating these factors into a principal-agent model. The principal adopts distinct strategies in response to each type of ambiguity. When ambiguity in production process increases, the principal reduces investment, shares ambiguity exposure with the agent, and delays payment to strengthen bargaining power position. In contrast, when facing exogenous shocks beyond the agent’s control, the principal mitigates firm internal risk and enhances stability by reducing capital investment in the risky production process, providing advance payments, and avoiding payoff reductions to preserve the agent’s incentives during shocks. These strategies emerge from the interaction between ambiguity and incentive design within the contracting framework. Notably, both types of ambiguity lose relevance under liquidation pressure, and production process ambiguity becomes insignificant when output is sufficiently high.