Moral Hazard with Limited Liability: Random-Variable Formulation and Optimal Contract Structures

43 Pages Posted: 6 Nov 2011 Last revised: 13 Nov 2019

See all articles by Wenbin Wang

Wenbin Wang

Shanghai University of Finance and Economics

Shanshan Hu

Indiana University - Kelley School of Business - Department of Operation & Decision Technologies

Date Written: September 3, 2019

Abstract

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

Wang, Wenbin and Hu, Shanshan, Moral Hazard with Limited Liability: Random-Variable Formulation and Optimal Contract Structures (September 3, 2019). Available at SSRN: https://ssrn.com/abstract=1954916 or http://dx.doi.org/10.2139/ssrn.1954916

Wenbin Wang (Contact Author)

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

Shanshan Hu

Indiana University - Kelley School of Business - Department of Operation & Decision Technologies ( email )

Business 670
1309 E. Tenth Street
Bloomington, IN 47401
United States
812-856-2342 (Phone)

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