The Cost of Moral Hazard and Limited Liability in the Principal-Agent Problem

Abstract

In the classical principal-agent problem, a principal hires an agent to perform a task. The principal cares about the task’s output but has no control over it. The agent can perform the task at different effort intensities, and that choice affects the task’s output. To provide an incentive to the agent to work hard and since his effort intensity cannot be observed, the principal ties the agent’s compensation to the task’s output. If both the principal and the agent are risk-neutral and no further constraints are imposed, it is well-known that the outcome of the game maximizes social welfare. In this paper we quantify the potential social-welfare loss due to the existence of limited liability, which takes the form of a minimum wage constraint. To do so we rely on the worst-case welfare loss—commonly referred to as the Price of Anarchy—which quantifies the (in)efficiency of a system when its players act selfishly (i.e., they play a Nash equilibrium) versus choosing a socially-optimal solution. Our main result establishes that under the monotone likelihood-ratio property and limited liability constraints, the worst-case welfare loss in the principal-agent model is exactly equal to the number of efforts available.