Robust Contract Designs: Linear Contracts and Moral Hazard

Abstract

Linear contracts and their variants are quite popular in practice, for example, salesforce incentives and chief executive officer compensation. However, agency theory typically stipulates complex contract forms. Yimin Yu and Xiangyin Kong provide an alternative explanation for the popularity of linear contracts: the robustness to model uncertainty renders the linear or generalized linear forms of the contracts under moral hazard. They adopt the worst-case decision criterion, and robust incentive compatibility to ensure that the agent always behaves. The results are robust to general effort-contingent distributions and the risk-averse agent. These findings also shed light on how to design robust contracts when firms are facing model uncertainty or incomplete model information.