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Budde, Jörg; Kräkel, Matthias (März 2008): 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.