Optimal Contracting with Moral Hazard and Behavioral Preferences∗

Abstract. We consider a continuous-time principal-agent model in which the agent’s effort cannot be contracted upon, and both the principal and the agent may have non-standard, cumulative prospect theory type preferences. We find that the optimal contracts are likely to be “more nonlinear ” than in the standard case with concave utility preferences. In the special case when the principal is risk-neutral, we show that she will offer a contract which effectively makes the agent less risk averse in the gain domain and less risk seeking in the loss domain, in order to align the agent’s risk preference better with the principal’s. We also find that the sensitivity of the contract may be larger than one, and increasing with output volatility