Optimal contract under double moral hazard and limited liability

Jiajia Cong () and Wen Zhou ()
Additional contact information
Jiajia Cong: Fudan University
Wen Zhou: The University of Hong Kong

Journal of Economics, 2021, vol. 134, issue 1, No 3, 49-71

Abstract: Abstract This paper investigates optimal contracts between risk-neutral parties when both exert efforts and the agent faces limited liability. We identify a sufficient and necessary condition for any contract to implement the second-best outcome, i.e., the best possible outcome in double moral hazard even when the agent faces unlimited liability. It is shown that a simple share-or-nothing with bonus contract (SonBo for short) is optimal and implements the second-best outcome when the condition holds. SonBo contracts have one degree of freedom, which is very useful in dealing with heterogeneous circumstances while still maintaining consistency in contracting. SonBo admits as special cases the option-like and step bonus contracts, which are widely used in dealing with limited liability. Nevertheless, we demonstrate that a step bonus contract is more powerful because an option-like contract can be problematic in some situations. The paper also discusses the performance of SonBo when the principal also faces liability constraint and investigates the optimal contract when the second-best outcome is not achievable.

Keywords: Double moral hazard; Limited liability; Optimal contract (search for similar items in EconPapers)
JEL-codes: D82 D86 M55 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://link.springer.com/10.1007/s00712-021-00737-9 Abstract (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:kap:jeczfn:v:134:y:2021:i:1:d:10.1007_s00712-021-00737-9

DOI: 10.1007/s00712-021-00737-9

Access Statistics for this article

Journal of Economics is currently edited by Giacomo Corneo

More articles in Journal of Economics from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().