Inducing Leaders to Take Risky Decisions: Dismissal, Tenure, and Term Limits

Abstract

How can a principal (employer or voter) induce an agent (worker or politician) to choose the 'right' actions if risky actions reveal the agent's decision-making competence and only dismissal can be used as an incentive instrument? The principal wishes to replace incompetent agents, but dismissal-fear can cause the agent to choose excessively safe actions that are uninformative. We first show that if the principal can commit to a replacement strategy in advance, then optimal mechanisms involve either (i) a probationary period and then indefinite tenure, or (ii) a dismissal strategy that replaces incompetent agents but also randomly replaces agents who take safe actions even if they are thought to be competent and may be taking an appropriate action. We characterize when each of these mechanisms is optimal. If the principal (e.g., a set of voters) regularly chooses whether to replace a leader, then whether or not efficiency is possible depends on the class of equilibria. Commitment-like behavior and approximate efficiency can be enforced in equilibria that use grim trigger-like strategies off-path, but efficiency is not possible in equilibria in which a new leader always provides a positive expected value, regardless of how competent a current leader is thought to be, and incentives can be improved by imposing term limits on leaders.