Bonuses and Penalties in Incentive Contracting

Abstract

Moral hazard in risk-sharing agreements often occurs when an agent's actions cannot be observed directly. We consider the case in which there is some observable measure of the agent's performance that varies continuously with the agent's effort. We analyze contracts that allow for lump-sum bonus and penalty payments contingent on performance and generally find them preferable to contracts in which the agent's reward depends continuously on observed performance.