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Endogenous Verifiability and Relational Contracting

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  • Ola Kvaløy
  • Trond E. Olsen

Abstract

Principal-agent models usually invoke the strong assumption that the parties know for sure ex ante whether a variable is verifiable or not. This paper assumes that only the probability of verification is known, and that this probability is endogenously determined. We analyze a principal-agent relationship where the verifiability of the agent's output is determined by the principal's investment in drafting an explicit contract. The model is well suited for analyzing the relationship between explicit contracting, legal courts, trust, and relational contracting. In particular, we show how trust -- established through repeated interaction -- and legal courts may induce contractual incompleteness. (JEL D82, D86)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.99.5.2193
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 99 (2009)
Issue (Month): 5 (December)
Pages: 2193-2208

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Handle: RePEc:aea:aecrev:v:99:y:2009:i:5:p:2193-2208

Note: DOI: 10.1257/aer.99.5.2193
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Citations

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Cited by:
  1. Hyytinen, Ari & Steen, Frode & Toivanen, Otto, 2013. "Anatomy of Cartel Contracts," CEPR Discussion Papers 9362, C.E.P.R. Discussion Papers.
  2. James Malcomson, 2010. "Relational Incentive Contracts," Economics Series Working Papers 508, University of Oxford, Department of Economics.
  3. Michael D. Ryall & Rachelle C. Sampson, 2009. "Formal Contracts in the Presence of Relational Enforcement Mechanisms: Evidence from Technology Development Projects," Management Science, INFORMS, vol. 55(6), pages 906-925, June.
  4. Kvaløy, Ola & Olsen, Trond E., 2010. "Incentive provision when contracting is costly," Discussion Papers 2010/10, Department of Business and Management Science, Norwegian School of Economics.
  5. Tore Ellingsen & Eirik Gaard Kristiansen, 2011. "Financial Contracting Under Imperfect Enforcement," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 323-371.
  6. Matthias Lang, 2012. "Communicating Subjective Evaluations," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2012_14, Max Planck Institute for Research on Collective Goods, revised Mar 2014.
  7. Martimort, David & Semenov, Aggey & Stole, Lars, 2014. "A Theory of Contracts With Limited Enforcement," MPRA Paper 53504, University Library of Munich, Germany.
  8. Sloof, Randolph & Sonnemans, Joep, 2011. "The interaction between explicit and relational incentives: An experiment," Games and Economic Behavior, Elsevier, vol. 73(2), pages 573-594.
  9. Hideshi Itoh & Hodaka Morita, 2011. "Formal Contracts, Relational Contracts, and the Threat-Point Effect," CESifo Working Paper Series 3533, CESifo Group Munich.
  10. Lumineau, Fabrice & Quelin, Bertrand, 2012. "An Empirical Investigation of Interorganizational Opportunism and Contracting Mechanisms," MPRA Paper 38362, University Library of Munich, Germany.
  11. Wu, Steven Y., 2013. "Adapting Contract Theory to Fit Contract Farming," 2014 Allied Social Science Association (ASSA) Annual Meeting, January 3-5, 2014, Philadelphia, PA 161894, Agricultural and Applied Economics Association.
  12. Hermalin, Benjamin E. & Li, Larry & Naughton, Tony, 2013. "The relational underpinnings of formal contracting and the welfare consequences of legal system improvement," Economics Letters, Elsevier, vol. 119(1), pages 72-76.
  13. Chen, Bo, 2012. "All-or-nothing payments," Journal of Mathematical Economics, Elsevier, vol. 48(3), pages 133-142.
  14. Manuel Willington & Roy Costilla, 2007. "Endogenous Verifiability and Optimality in Agency: A non-contingent approach," ILADES-Georgetown University Working Papers inv189, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.

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