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2012 Documento de Trabajo #291

On the Optimality of One-size-fits-all Contracts: The Limited Liability Case

In this paper I study a multi-task principal agent model with a risk-neutral principal and a risk neutral agent subject to limited liability in an environment with adverse selection and moral hazard. The main results are as follows: (1) the optimal contracts in each possible case is a bonus-type contract that pays a bonus only when the highest signal is realized; (2) the informational rent as well as the limited liability rent are not independent; and (3) under moral and adverse selection the bonus contract exhibits a one-size-fits-all property; that is, in equilibrium all agents are offered the same contract. Under this contract more talented agents work harder and have a higher expected payoff and are on average more productive than less talented agents. This provides a rationale for the absence of menu of contracts in many different settings such as sales contracts, debt contracts, farming workers and optimal regulation.

JEL-Classification: D82, D86, J33.

Felipe Balmaceda

Keywords: Adverse Selection, Limited Liability., moral hazard, Multiple Tasks