Optimal investment by the principal in order to increase the probability of favourable states of nature in the principal-agent model with moral hazard

This paper analyses the single agent, principal-agent model with moral hazard. This model differs from other models that have been formulated in that in this model the principal is allowed to make an investment that increases the probability of higher levels of output. The principal must take into account the agent’s reaction to the investment in making the investment decision. The paper also shows that conventional wisdom about the relationship between compensation and uncertainty, and the optimal level of investment may only hold under restrictive assumptions when the principal is allowed to invest.