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Contract Bargaining with a Risk-Averse Agent

Abstract This article is the first to study a bargaining model in a moral hazard framework where the principal is risk neutral and the agent is risk averse. We show that the power of incentives increases with the agent’s bargaining power if the contracts induce a high effort. However, under reasonable assumptions about the agent’s utility function, the contracts induce a high effort less often as the agent’s bargaining power increases. As for the social welfare, we are surprised to find that a utilitarian, who cares about the sum of the two parties’ certainty equivalents, is worse off as the agent’s bargaining power increases. These results are in sharp contrast to the literature, which features risk-neutral agents protected by limited liability.