The Employment Contract as a Lottery

The existing principal-agent models either assume that the agent is risk-averse or risk-neutral. However, in reality people appear to value insurance in some situations while enjoy risk in others. This paper revisits the standard principal-agent problem under the assumption that the agent’s preferences can be described by a utility function proposed by Friedman and Savage (1948) to capture the above con‡icting attitudes towards risk. Unlike in the standard framework with a risk-averse agent, the second best contract in the present model can achieve full e¢ciency under a range of parameter values. Moreover, the optimal contract frequently resembles simple contracts used in practice – a bonus scheme, a promotion tournament, or a stock option grant.

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