Standards and Incentives under Moral Hazard with Limited Liability

We consider a model of moral hazard with limited liability of the
agent and effort that is two-dimensional. One dimension of the
agent’s effort is observable and the other is not. The principal
can thusmake the contract conditional not only on outcome but also
on observable effort. The principal’s optimal contract gives the
agent no rent and – in contrast to the first-best allocation – uses
toomuch observable effort and too little unobservable effort. This
distortion in the relative use of the two kinds of effort increases
if the agent’s liability becomes more limited.