Abstract. We extend the principal-agent model of moral hazard with limited liability by introducing uncertainty and private information concerning the principal’s reservation payoff. We characterize the principal’s optimal design of her own exit rights from the incentive contract and show that it exhibits a trade-off between securing the agent’s investments and preserving the flexibility to terminate the contract when opportunity costs are high. The principal generically over or under secure the agent with respect to the socially optimal security level and may find it optimal to commit to pay a liquidation fee to the agent if she terminates the project. We also show that imposing a regulated minimal liquidation fee is socially optimal therefore providing an efficiency rationale for employment protection laws that impose a minimal worker’s indemnity for contractual terminations.
Works in progress.
Summary. In a general principal-agent framework with binary moral hazard, short-term and long-term contracting under limited commitment is compared to interim contracting. When communication is restricted to direct (face-to-face) mechanisms, both contracting games sustain the same optimal equilibrium payoff for the principal as under interim contracting. With mediated communication, however, long-term contracting with limited commitment enhances both effort provision and the agent's payoff relative to interim contracting. In contrast, short-term contracts improve the principal's payoff only when interim-efficient information rents are non-monotonic in the probability of high effort. In such cases, optimal short-term contracts may further restrict effort provision.