Limited Liability Contracts Between Principal and Agent

Abstract

The optimal strategy of the principal is examined in an environment where there are (ex post) limitations on the maximum penalty than can be imposed on a risk-neutral agent. Contrary to the case in which such limitations are not imposed, it is in the principal's interest to deliberately forego the opportunity to induce socially efficient behavior, and to instead design a contract that induces the agent to realize an efficient outcome only in the most productive state of nature and (perhaps) in certain very unproductive states. The properties of the contract are examined in detail. Journal of Economic Literature Classification Numbers: 022, 026, 610