Agent's liability versus principal's liability when Attitudes toward Risk Differ

This paper studies through an agency model the problem of concealing an illegal activity which benefits the principal. The agent can exert an effort that negatively affects the likelihood of detection. We model such behavior with the assumption that the principal is risk neutral while the agent is risk averse. Two opposite legal regimes are considered: in the first, only the principal is strictly liable; in the second, only the agent is. We show that shifting the liability upon the agent, while the monetary sanction and the probability of detection are kept constant, reduces the principal's net benefit, thus favoring deterrence of wrongdoing. However, the agent's effort in cheating can either increase or decrease. For a specific model we are able to characterize cases in which a reduction in cheating prevails, and shifting the liability upon the agent has clear-cut beneficial effects on compliance.