DP7914 Optimal Incentive Contracts under Moral Hazard When the Agent is Free to Leave

Author(s): Florian Englmaier, Gerd Muehlheusser, Andreas Roider
Publication Date: July 2010
Keyword(s): ex-post outside option, limited commitment, limited liability, moral hazard
JEL(s): D82, D86, K31, M52
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7914

We characterize optimal incentive contracts in a moral hazard framework extended in two directions. First, after effort provision, the agent is free to leave and pursue some ex-post outside option. Second, the value of this outside option is increasing in effort, and hence endogenous. Optimal contracts may entail properties such as inducing first-best effort and surplus, or non-responsiveness with respect to changes in verifiable parameters. Moreover, while always socially inefficient, separation might occur in equilibrium. Except for the latter, these findings are robust to renegotiation. When the outside option is exogenous instead, the standard results obtain.