Moral Hazard and Limited Liability

Jacques Lawarree and Marc van Audenrode
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Marc van Audenrode: Universite Laval

No 971, Econometric Society World Congress 2000 Contributed Papers from Econometric Society

Abstract: Real world contracts limit the liabilities of agents by imposing constraints on their transfers or on their utilities. In an adverse selection model, Sappington (1983) has shown that the two constraints yield an equivalent problem for the principal. We show that this result does not hold in a moral hazard framework. More specifically, we show that restrictions on the utilities are stronger in the sense that they yield a lower level of effort from the agent. Moreover, given an optimal contract constrained by a limited liability on utility, one can always find a Pareto dominating contract constrained by a limited liability on transfers.

Date: 2000-08-01
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