Standards and Incentives under Moral Hazard with Limited Liability

Published: Feb. 1, 2012, 11 a.m.

b'We consider a model of moral hazard with limited liability of the agent and effort that is two-dimensional. One dimension of the agent\\u2019s effort is observable and the other is not. The principal can thusmake the contract conditional not only on outcome but also on observable effort. The principal\\u2019s optimal contract gives the agent no rent and \\u2013 in contrast to the first-best allocation \\u2013 uses toomuch observable effort and too little unobservable effort. This distortion in the relative use of the two kinds of effort increases if the agent\\u2019s liability becomes more limited.'