Limited liability constraints in adverse selection and moral hazard problems

This paper analyzes a principal-agent model in which the agent has private information before contracting with the principal and ex-post private decision. These inputs determine the random output accruing to the principal. We characterize the optimal menu of contracts between a risk-neutral principal and a risk-neutral agent when the agent has limited liability on his transfer or utility levels. We show that the lessons from the basic agency literature do not straightforwardly extend in this more complex environment. We highlight a key feature of these contracts: the agent faces endogenous countervailing incentives. The agent has an incentive to understate his efficiency due to the presence of adverse selection, and to overstate it for limited liability reasons.