How Costly are Limited Liability Rules?

39 Pages Posted: 3 May 1999

See all articles by Michel A. Robe

Michel A. Robe

University of Illinois at Urbana-Champaign

Date Written: February 1999

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.

JEL Classification: G32, D82

Suggested Citation

Robe, Michel A., How Costly are Limited Liability Rules? (February 1999). Available at SSRN: https://ssrn.com/abstract=162608 or http://dx.doi.org/10.2139/ssrn.162608

Michel A. Robe (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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