Budde, Jörg and Kräkel, Matthias
Limited Liability and the Risk-Incentive Relationship.
SFB/TR 15 Discussion Paper No. 232
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 empirical 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 increasing the weight on the signal and, hence, choosing higher-powered incentives.