How Costly Are Limited Liability Rules?

Abstract:     
We analyze the optimal contract, and quantify the cost of limited liability rules, in a standard agency model with ex-ante action choices. Under limited liability, we show that, for typical parametrizations, compensation contracts always specify a "performance target" for the risk-averse agent. Alternatively, in a model of investment financing under moral hazard, external debt and the granting of absolute priority to debtholders are key (though not the unique) ingredients of the optimal financing contract. Removing liability limits makes possible a superior contract that punishes the agent harshly for low-output results. We interpret these harsh penalties in terms of debt bondage (or debtors' prisons), and show that the deadweight losses brought about by the judicial imposition of liability limits are significant. Our results indicate that the costs associated with debt bondage must be substantial to explain the ubiquity of limited liability rules in modern economies.

Number of Pages in PDF File: 39

JEL Classification: G32, D82

working papers series