Optimal contracting with moral hazard and behavioral preferences

We consider a continuous-time principal–agent model in which the agent's effort cannot be contracted upon, and both the principal and the agent may have non-standard, cumulative prospect theory type preferences. We find that the optimal contracts are likely to be “more nonlinear” than in the st...

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Bibliographic Details
Published in:Journal of mathematical analysis and applications 2015-08, Vol.428 (2), p.959-981
Main Authors: Chang, Hualei, Cvitanić, Jakša, Zhou, Xun Yu
Format: Article
Language:English
Subjects:
Backward stochastic differential equation
Contracts
Control
Cumulative prospect theory
Moral hazard
Principal–agent problem
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Summary:We consider a continuous-time principal–agent model in which the agent's effort cannot be contracted upon, and both the principal and the agent may have non-standard, cumulative prospect theory type preferences. We find that the optimal contracts are likely to be “more nonlinear” than in the standard case with concave utility preferences. In the special case when the principal is risk-neutral, we show that she will offer a contract which effectively makes the agent less risk averse in the gain domain and less risk seeking in the loss domain, in order to align the agent's risk preference better with the principal's.
ISSN:0022-247X
1096-0813
DOI:10.1016/j.jmaa.2015.03.027