The form of incentive contracts: agency with moral hazard, risk neutrality and limited liability

The analysis obtains a complete characterization of the optimal agency contract with moral hazard, risk neutrality, and limited liability. We introduce a “critical ratio” that indicates the returns to providing the agent with incentives for effort in each random state. The form of the contract is debt (a capped bonus) when the critical ratio is increasing (decreasing) in the state. An increasing critical ratio in the state-space setting corresponds to the hazard rate order for the reduced-form distribution of output, which we term the “decreasing hazard rate in effort property” (DHREP). The critical ratio also yields insights into agency with adverse selection.