Background Risk in the Principal-Agent Model

We examine the effect of background risk in the standard two-state, two-action principal-agent model. We analyse situations where the background risk is environmental (always present) and where the background risk is contractual (only present if the contract is accepted). With contractual background risk, expected wages always rise and the incentive scheme is flatter if the agent's preferences satisfy weak decreasing absolute risk aversion. With environmental background risk, the optimal incentive scheme becomes flatter if the agent is weakly prudent. We provide conditions under which the environmental background risk decreases the agent's expected wage.