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Limited Liability and the Risk-Incentive Relationship

By Jörg Budde and Matthias Kräkel

Abstract

moral hazard, limited liability, risk-incentive relationship Abstract: Several empirical findings have challenged the traditional view on the trade-off between risk and incentives. By combining risk aversion and limited liability in a standard principal-agent model the empiri- cal puzzle on the positive relationship between risk and incentives can be explained. Increasing risk leads to a less informative performance signal. Under limited liability, the principal may optimally react by in- creasing the weight on the signal and, hence, choosing higher-powered incentives.

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