Moral Hazard and Clear Conscience∗

The hidden-action moral hazard model is one of the cornerstones of contract theory and it has become a basic tool to analyze job contracts and other agency relationships. Close social ties often implied by such relationships make the moral hazard model a prime application of approaches where agents care about inequity, and intrinsically reciprocate each others’ kind and hostile intentions. We contribute to this literature by considering how the optimal contract is affected if agreed with an agent who feels bad when not reaching a target effort set in the contract. Guilt makes effort partially contractible even without any monitoring. Not surprisingly, higher effort can be implemented with lower risk and the solution is closer to first-best. Nevertheless, using the target effort to induce effort is not entirely costless for the principal. In equilibrium, the agent fails to provide the required effort. This induces guilt which must be compensated for by the principal, for otherwise the agent would not accept the job in the first place. Thus, both the principal and the agent are more pleased with the generated monetary return unlike suggested by previous social preference applications to optimal contracts.