The Limit Contract in the Standard Agency Model

Abstract

One major difficulty with the standard agency model is that it generally does not provide a closed-form solution. A second major difficulty is that the theory relies on the troublesome first-order approach. To avoid these difficulties but at the same time to allow a general utility function, many economists simply assume away uncertainty and find an optimal linear contract in an environment of certainty. We argue that the linear contract is not robust when the economy fluctuates. Instead, we identify the limit contract as uncertainty diminishes. The limit contract is robust, simple and intuitive. And, in an environment with small uncertainty, it has the same properties as the optimal contract and it is a good approximation of the optimal contract.