Optimal agency contracts: The effect of vicarious liability and judicial error

Under the doctrine of vicarious liability, a deep-pocket principal is often held responsible for a third-party harm caused by a judgment-proof agent's negligence. We analyze the incentive contract used by the principal to control the agent's behavior when a court can make an error in determining the agent's negligence. We show that (1) reducing the error of declaring the agent not negligent even when he was (pro-defendant or type II error) is better than reducing the error of declaring the agent negligent even when he was not (pro-plaintiff or type I error) and (2) allowing the principal to penalize the agent even when the court declares the agent not negligent improves welfare. The latter supports the argument that causing an accident (or a reliable allegation of misconduct) should be sufficient to justify a "just cause" termination of an employee. (C) 2008 Elsevier Inc. All rights reserved.