Incentive Contracts, Optimal Penalties and Enforcement

Abstract

This paper re-examines the literature on optimal penalties and the allocation of resources to enforcement from the viewpoint of incentive theory. It is assumed that an agent might perform a socially harmful act. In contrast to previous analyses, the agent might also perform profit-enhancing actions for the principal. The principal cannot distinguish between the good and harmful acts, but can set incentives based on observed profits. When the agent is wealth constrained, it is demonstrated that it is optimal to hold the principal liable for the agent's actions and to set the optimal penalty equal to expected harm caused. This is because the imposition of high penalty levels causes the principal to dilute incentives for the agent, resulting in a reduction in productivity. The same logic also means that it is optimal to devote some resources to enforcement and to impose penalties on both principal and agent if that is feasible.

JEL Classification: K14, K42