Flexibility Versus Security in Agency Contracts with Moral Hazard

Lorenzo Bozzoli () and Guillaume Pommey ()
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Lorenzo Bozzoli: Toulouse School of Economics
Guillaume Pommey: DEF, University of Rome "Tor Vergata", http://www.ceistorvergata.it

No 621, CEIS Research Paper from Tor Vergata University, CEIS

Abstract: We study agency contracts where a project owner (principal) privately learns her opportunity cost of continuing the relationship after the agent’s effort is sunk. The principalcontrols the design of termination rights and faces a trade-off between preserving incentives and retaining exit flexibility. Even without legal constraints, fully flexible (at-will), fully rigid (lock-in), and intermediate contracts offering partial security and compensation can all arise at equilibrium. While some contractsmay appear to protect the agent, they are always socially inefficient, justifying targeted legal constraints on termination rights. In particular, at-will contracts always under-secure the agent and under-enforce the project and can be banned on efficiency grounds. Inefficiencies also include excessive termination payments and over-securing, suggesting both toomuch and too little flexibility distort outcomes. Finally, we characterize aminimalmandatory termination fee, as commonly seen in employment protection laws, that partially restores efficiency

Keywords: Moral Hazard; Termination rights; Severance Pay; Commitment (search for similar items in EconPapers)
JEL-codes: D86 J33 J65 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2026-06-16, Revised 2026-06-16
New Economics Papers: this item is included in nep-mic
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