LIMITED-LIABILITY AND INCENTIVE CONTRACTING WITH EX-ANTE ACTION CHOICES

This article examines a principal-agent model of financial contracting in which a risk-neutral entrepreneur (agent) makes an unobservable ex-ante effort choice while employing the investment funds of a risk-neutral investor (principal). The key innovation is that the investment contract is subject to statutory liability limits. Given these liability limits, two settings are considered, one in which the investor payoff function is also constrained to be monotonically nondecreasing in firm profit, and another in which no such "monotonic contract" constraint is imposed. In the former case, a standard debt contract is shown to emerge and a "first best" effort choice is not achieved. In the latter setting, the optimum is characterized by a "live-or-die" payoff function, and a "first best" effort level may or may not be realized. © 1990.