‘Incentive conscious’ agents and moral hazard

This paper characterizes the structure of monetary incentives with varying agent incentive-consciousness. Incentive consciousness arises when the valuation of incentive among agents differs with situations. Using a moral hazard framework with limited liability we show that for agents with low outside option optimal incentive pay is independent of incentive-consciousness whereas for agents with high outside option increased incentive-consciousness leads to increased incentive payment. For agents with very high incentive-consciousness such that the limited liability does not bind, an exogenous increase in incentive-consciousness leads to an unambiguous decrease in optimal incentive payment. Thus, the paper provides a non-monotonic relation between incentive consciousness and optimal incentive pay. With incentive-consciousness, inefficiency in the effort will exist with risk-neutral principal and agent even in the absence of limited liability. This runs contrary to standard incentive theory.