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Optimal contracts in a dynamic costly state verification model

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  • Cyril Monnet

    ()

  • Erwan Quintin

    ()

Abstract

This paper describes optimal contracts in a dynamic costly state verification model with stochastic monitoring. An agent operates a risky project on behalf of a principal who can observe the project’s revenues at a cost. We show that an optimal contract exists such that, at any history, either the principal claims the project’s entire revenues or promises to claim nothing in the future. In particular, the agent’s expected income rises with time. Moreover, except in at most one period, the principal claims all revenues when audit occurs. We provide conditions under which all optimal contracts satisfy these properties. Copyright Springer-Verlag Berlin/Heidelberg 2005

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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 26 (2005)
Issue (Month): 4 (November)
Pages: 867-885

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Handle: RePEc:spr:joecth:v:26:y:2005:i:4:p:867-885

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Related research

Keywords: Dynamic contracts; Theory of uncertainty and information; Costly state verification; Monitoring.;

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References

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  1. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
  2. Chang, Chun, 1990. "The dynamic structure of optimal debt contracts," Journal of Economic Theory, Elsevier, vol. 52(1), pages 68-86, October.
  3. Bruce D. Smith & Cheng Wang, 1997. "Repeated insurance relationships in a costly state verification model: with an application to deposit insurance," Working Papers 574, Federal Reserve Bank of Minneapolis.
  4. Border, Kim C & Sobel, Joel, 1987. "Samurai Accountant: A Theory of Auditing and Plunder," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 525-40, October.
  5. Thomas Cooley & Ramon Marimon & Vincenzo Quadrini, 2004. "Aggregate Consequences of Limited Contract Enforceability," Journal of Political Economy, University of Chicago Press, vol. 112(4), pages 817-847, August.
  6. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  7. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
  8. Williamson, Stephen D, 1987. "Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 102(1), pages 135-45, February.
  9. Albuquerque, R. & Hopenhayn, H.A., 1997. "Optimal Dynamic Lending Contracts with Imperfect Enforceability," RCER Working Papers 439, University of Rochester - Center for Economic Research (RCER).
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Citations

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Cited by:
  1. Roc Armenter & Thomas M. Mertens, 2010. "Fraud deterrence in dynamic Mirrleesian economies," Working Papers 10-7, Federal Reserve Bank of Philadelphia.
  2. Ethan Cohen-Cole & Enrique Martínez-García, 2011. "The Balance Sheet Channel," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 9, pages 255-297 Central Bank of Chile.
  3. Edward Simpson Prescott, 2004. "Auditing And Bank Capital Regulation," Working Papers wp2004_0412, CEMFI.
  4. Harold L. Cole, 2008. "Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims," NBER Working Papers 14480, National Bureau of Economic Research, Inc.
  5. Langberg, Nisan, 2008. "Optimal financing for growth firms," Journal of Financial Intermediation, Elsevier, vol. 17(3), pages 379-406, July.
  6. Ravikumar, B. & Zhang, Yuzhe, 2010. "Optimal Auditing in a Dynamic Model of Tax Compliance," MPRA Paper 23218, University Library of Munich, Germany.
  7. Cole, Harold L., 2013. "Self-enforcing stochastic monitoring and the separation of claims," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 632-649.
  8. Zhang, Yuzhe & Ravikumar, B., 2012. "Optimal auditing and insurance in a dynamic model of tax compliance," Theoretical Economics, Econometric Society, vol. 7(2), May.
  9. Meeks, Roland, 2012. "Do credit market shocks drive output fluctuations? Evidence from corporate spreads and defaults," Journal of Economic Dynamics and Control, Elsevier, vol. 36(4), pages 568-584.
  10. Karel Janda, 2006. "Lender and Borrower as Principal and Agent," Working Papers IES 2006/24, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Jul 2006.

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