Optimal Contract Under Double Moral Hazard and Limited Liability

This paper investigates optimal contracts between risk-neutral parties when both exert efforts and the agent faces limited liability. It is shown that a simple share-or-nothing with bonus contract (SonBo for short) is optimal and implements the second-best outcome, i.e., the best possible outcome in double moral hazard even when the agent faces unlimited liability. No other contract can do better than SonBo. SonBo contracts have one degree of freedom, which is useful in dealing with heterogeneous circumstances while still maintaining consistency in contracting. Between the two instruments of SonBo, the bonus component is more important than the output share