Moral Hazard with Limited Liability: Random-Variable Formulation and Optimal Contract Structures
43 Pages Posted: 6 Nov 2011 Last revised: 13 Nov 2019
Date Written: September 3, 2019
This paper studies the optimal contract for a risk-neutral agency with limited liability. We introduce a novel formulation of the model, in which the contract design problem reduces to a problem of constructing the distribution function of a random variable. This formulation directly balances the principal's tradeoff between incentivizing the agent to exert proper effort and minimizing the cost of the agent's compensation. We show that the optimal contract may involve one or two tiers of performance-based bonuses. We obtain new sufficient conditions for the optimality of bonus contracts and provide new insights into the choice of contract parameters.
Keywords: moral hazard, risk-neutral agency, limited liability, first-order approach, pay-for-performance
JEL Classification: D82, D86
Suggested Citation: Suggested Citation