Moral Hazard with Limited Liability: The Random-Variable Formulation and Optimal Contract Structures
30 Pages Posted: 6 Nov 2011 Last revised: 10 Nov 2016
Date Written: November 1, 2016
We consider an important category of agency models: the moral hazard problem between a principal and an agent with limited liability. We introduce a new way of formulating the model, where the contract design problem reduces to a problem of constructing the distribution function of a random variable. This formulation allows to directly balance the central tradeoff in the agency problem: maximizing the principal’s payoff as well as incentivizing the agent to exert effort or take proper risk.
Our new method overcomes the limitation of the standard first-order-approach in solving the moral hazard problems in practice. Several structural results are established about the optimal contracts. We are the first to report that the optimal contract may involve two tiers of performance-based bonuses. In regard to the widely used bonus contract, we obtain new sufficient conditions for its optimality and provide new insights about setting the bonus-triggering threshold and bonus size.
Keywords: moral hazard, risk-neutral agency, limited liability, first-order approach, pay-for-performance
JEL Classification: D82, J33
Suggested Citation: Suggested Citation