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Bounds on the welfare loss from moral hazard with limited liability

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  • Balmaceda, Felipe
  • Balseiro, Santiago R.
  • Correa, José R.
  • Stier-Moses, Nicolás E.

Abstract

We study a principal–agent problem with discrete outcome and effort level spaces. The principal and the agent are risk neutral and the latter is subject to limited liability. Quantifying welfare loss as the ratio between the first-best social welfare and that arising from the principal's optimal pay-for-performance contract, we provide simple parametric bounds for problem instances with moral hazard. Relying on that, we compute the worst-case welfare loss ratio among all problem instances with a fixed number of effort and outcome levels as a function of the number of possible effort levels and the likelihood ratio evaluated at the highest outcome. As extensions, we look at linear contracts and at cases with multiple identical tasks. Our work constitutes an initial attempt to quantify the losses arising from moral hazard when the agent is subject to limited liability, and shows that these losses are non-negligible in the worst case.

Suggested Citation

  • Balmaceda, Felipe & Balseiro, Santiago R. & Correa, José R. & Stier-Moses, Nicolás E., 2016. "Bounds on the welfare loss from moral hazard with limited liability," Games and Economic Behavior, Elsevier, vol. 95(C), pages 137-155.
    • Handle: RePEc:eee:gamebe:v:95:y:2016:i:c:p:137-155
    DOI: 10.1016/j.geb.2015.10.008
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    Cited by:

    1. Felipe Balmaceda, 2020. "Contracting with moral hazard, adverse selection and risk neutrality: when does one size fit all?," International Journal of Game Theory, Springer;Game Theory Society, vol. 49(2), pages 601-637, June.

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    More about this item

    Keywords

    Principal–agent problem; Moral hazard; Limited liability; Welfare loss; Price of anarchy;
    All these keywords.

    JEL classification:

    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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