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Optimal Incentive Contracts With Bonus Caps

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  • Chang Koo Chi
  • Trond E. Olsen

Abstract

This article investigates contracts between two risk‐neutral parties with bounded bonus payments. If the available signal about the agent's behavior satisfies a novel condition, the monotone likelihood ratio transformation property, the optimal contract takes a simple form irrespective of whether the first‐order approach (FOA) is valid or not. The contract rewards the agent the maximum bonus if the signal's likelihood ratio exceeds a threshold, which in contrast to the FOA contract is not necessarily zero. We next derive a condition for a signal to enhance the efficiency of a contract. Applications in relational contracting and law enforcement illustrate our findings.

Suggested Citation

  • Chang Koo Chi & Trond E. Olsen, 2025. "Optimal Incentive Contracts With Bonus Caps," RAND Journal of Economics, RAND Corporation, vol. 56(1), pages 55-73, March.
    • Handle: RePEc:bla:randje:v:56:y:2025:i:1:p:55-73
    DOI: 10.1111/1756-2171.12491
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