Double-Sided Moral Hazard, Efficiency Wages and Litigation

We consider a moral-hazard problem in a principal-agent relationship. Each party can renege on the signed contract since verification of effort is costly and subject to uncertainty. It is shown that ex-post litigation can restore incentives of the agent. Moreover, when the litigation can be settled by the parties the pure threat of using the legal system may suffice to implement the first-best solution. This finding is quite robust. In particular, it holds for situations where the agent is protected by limited liability, where the parties have different technologies in the litigation contest, or where the agent is risk averse. (JEL D86, J33, K41) * University of Bonn. Email: [email protected]. ** University of Bonn. Email: [email protected]. We would like to thank two anonymous referees, the co-editor Keith Crocker, Uschi Backes-Gellner, Patrick Bolton, Kike de la Rosa, Mathias Dewatripont, Sebastian Kranz, Florian Morath, Tymofiy Mylovanov, Georg Nöldeke, Kerstin Pull as well as participants in the seminars at Basel and Zurich and the Young Researchers Workshop on "Contests and Tournaments" in Berlin for helpful comments. Financial support by the Deutsche Forschungsgemeinschaft (DFG), grant SFB/TR 15 (”Governance and the Efficiency of Economic Systems”), is gratefully acknowledged.