The Theory of Incentives: The Principal-Agent Model

By Jean-Jacques Laffont; David Martimort | Go to book overview

5
Incentive and
Participation Constraints
with Moral Hazard *

In chapter 4, we stressed the various conflicts that may appear in a moral hazard environment. The analysis of these conflicts, under both limited liability and risk aversion, was made easy because of our focus on a simple 2 × 2 environment with a binary effort and two levels of performance. The simple interaction between a single incentive constraint with either a limited liability constraint or a participation constraint was quite straightforward.

However, moral hazard models also inherit the major difficulties of Incentive Theory, which we have already encountered in our investigation of complex adverse selection models carried out in chapter 3. Indeed, when one moves away from the 2 × 2 (by far too simplistic) model of chapter 4, numerous incentive constraints have to be taken into account in complex moral hazard environments. The analysis becomes much harder, and characterizing the optimal incentive contract is a difficult task. Examples of such complex contracting environments abound.

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