Optimal Incentive Contracts With Bonus Caps

Chang Koo Chi and Trond E. Olsen

RAND Journal of Economics, 2025, vol. 56, issue 1, 55-73

Abstract: This article investigates contracts between two risk‐neutral parties with bounded bonus payments. If the available signal about the agent's behavior satisfies a novel condition, the monotone likelihood ratio transformation property, the optimal contract takes a simple form irrespective of whether the first‐order approach (FOA) is valid or not. The contract rewards the agent the maximum bonus if the signal's likelihood ratio exceeds a threshold, which in contrast to the FOA contract is not necessarily zero. We next derive a condition for a signal to enhance the efficiency of a contract. Applications in relational contracting and law enforcement illustrate our findings.

Date: 2025
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https://doi.org/10.1111/1756-2171.12491

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