Resolving Double Moral Hazard Problems with Buyout Agreements

Abstract

We consider a double moral hazard problem in which the efforts of two parties, e.g., a principal who initially owns an enterprise and a risk averse agent in the enterprise, are not verifiable.The realized value of the enterprise's random profit stream is also unverifiable.There is also no third party to break a "balanced budget" requirement.Nevertheless, the double moral hazard problem can be resolved completely and costlessly when the principal, who can observe the agent's actions, has the option of requiring the agent to purchase the enterprise at a prenegotiated price.