The form of incentive contracts: agency with moral hazard, risk neutrality, and limited liability

Authors


  • We thank the coeditor David Martimort and two anonymous referees for their helpful and insightful comments that greatly improved the article. We also thank Sandeep Baliga, Marco Ottaviani, Yuk-fai Fong, Yongmin Chen, Pierre-Andre Chiappori, Tom Gresik, Scott Kominers, Alessandro Pavan, David Sraer, and Glen Weyl for interesting and useful comments. Poblete is grateful to the Searle Center on Law, Regulation, and Economic Growth for research support. Spulber is grateful for the support of a research grant from the Ewing Marion Kauffman Foundation on Entrepreneurship. We also thank session participants at the American Economic Association Meetings in Chicago, 2012.

Abstract

The analysis obtains a complete characterization of the optimal agency contract with moral hazard, risk neutrality, and limited liability. We introduce a “critical ratio” that indicates the returns to providing the agent with incentives for effort in each random state. The form of the contract is debt (a capped bonus) when the critical ratio is increasing (decreasing) in the state. An increasing critical ratio in the state-space setting corresponds to the hazard rate order for the reduced-form distribution of output, which we term the “decreasing hazard rate in effort property” (DHREP). The critical ratio also yields insights into agency with adverse selection.

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