Optimal Contracts with a Risk-Taking Agent
Consider an agent who can costlessly add mean-preserving noise to his output. To deter such risk-taking, the principal optimally offers a contract that makes the agent's utility concave in output. If the agent is risk-neutral and protected by limited liability, optimal incentives are strikingly simple: linear contracts maximize profit. If the agent is risk averse, we characterize the unique profit-maximizing contract and show how deterring risk-taking affects the insurance-incentive tradeoff. We extend our model to analyze costly risk-taking and alternative timings, and reinterpret our model as a dynamic setting in which the agent can manipulate the timing of output.