Moral Hazard and Clear Conscience

We consider guilt averse agents and principals and study the effects ofguilt on optimal behavior of the principal and the agent in a moral hazardmodel.The principal’s contract proposal contains a target effort in addition tothe monetary incentive scheme. By accepting the agreement, the partiesagree on both the wage scheme and the target.The agent suffers from guilt when failing to provide the target effort,the principal when paying less than the contract requires or when settingan unreasonably high target effort.In equilibrium, a guilt-prone agent chooses a higher effort than anagent who only cares about monetary incentives. The target effort level isalways set above the equilibrium effort. Both the agent and the principalgain from the agent’s guilt aversion.A principal who lacks power to commit to the proposed incentivescheme benefits from having a positive proneness to guilt. However, aguilt-prone principal who suffers when setting an unreasonable target isworse off than one with merely monetary motivations.