Moral hazard and bargaining over incentive contracts

•We examine bargaining over incentive contracts in a principal-agent framework.•We compare the outcomes of the Nash and the Kalai–Smorodinsky solutions.•Nash solution induces more effort if the worker׳s bargaining power is small.•If the worker׳s bargaining power is high, the KS solution is more efficient.•Raising the worker׳s bargaining power can improve efficiency.

This paper analyses bargaining over an incentive compatible contract in a moral hazard framework. We introduce the Kalai–Smorodinsky bargaining solution and compare the outcome with the commonly applied Nash solution. Whether worker׳s effort is higher in the Nash or the Kalai–Smorodinsky solution depends on the agents׳ bargaining power. The social planner can mitigate inefficiencies arising in both bargaining solutions from the moral hazard problem and even achieve the first-best outcome by allocating the agents׳ bargaining power. If raising the worker׳s bargaining power is necessary to achieve the first-best solution, this increase must be higher in the Nash solution than in the Kalai–Smorodinsky solution.