The Moral Hazard Problem with High Stakes, Journal of Economic Theory
We study the moral-hazard problem when the agent's reservation utility is large, but so is the agent's value to the principal. We show that the principal's cost of implementing effort has a very simple limiting form. For large enough outside option, the principal's cost is convex in the action, so the optimally-implemented action is unique, and optimal effort rises with the agent's ability, and falls with the agent's wealth and outside option. In a competitive market setting where heterogenous principals and agents match, positive sorting ensues and effort increases in match quality, despite conflicting forces.
Jeroen Swinkels, Hector Chade
Swinkels, Jeroen, and Hector Chade. 2020. The Moral Hazard Problem with High Stakes. Journal of Economic Theory. 187READ