Bargaining to Design Contracts under Moral Hazard

This paper presents a simple bargaining model in a contracting situation betweena risk-neutral principal and a risk-averse agent with limited liability. An increasein the agent's bargaining power has two effects. First, the negotiated contracts provide the agent a higher reward, which gives stronger incentive to exert effort. Second, the agent, whose marginal utility decreases with increasing income, exerts less effort, given the same reward, when the equilibrium income increases with the bargaining power. Therefore, we can show there is an inverted-U-shape relationship between agent's effort level and agent's bargaining power.