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Flexibility Versus Security in Agency Contracts with Moral Hazard

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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

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  • Lorenzo Bozzoli & Guillaume Pommey, 2026. "Flexibility Versus Security in Agency Contracts with Moral Hazard," CEIS Research Paper 621, Tor Vergata University, CEIS, revised 16 Jun 2026.
    • Handle: RePEc:rtv:ceisrp:621
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    Keywords

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    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings

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