DP6725 Repeated Moral Hazard, Limited Liability, and Renegotiation

Author(s):	Susanne Ohlendorf, Patrick W. Schmitz
Publication Date:	February 2008
Keyword(s):	Dynamic moral hazard, hidden actions, limited liability
JEL(s):	C73, D86
Programme Areas:	Industrial Organization
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=6725

We consider a repeated moral hazard problem, where both the principal and the wealth-constrained agent are risk-neutral. In each of two periods, the principal can make an investment and the agent can exert unobservable effort, leading to success or failure. Incentives in the second period act as carrot and stick for the first period, so that effort is higher after a success than after a failure. If renegotiation cannot be prevented, the principal may prefer a project with lower returns; i.e., a project may be "too good" to be financed or, similarly, an agent can be "overqualified."