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Optimal contracts in a dynamic costly state verification model

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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 over several periods. Each period, the principal can observe the revenues from the project provided he incurs a fixed cost. We show that an optimal contract exists with the property that, in each period and for every possible revenue announcement by the agent, either the principal claims the entire proceeds from the project or promises to claim nothing in the future. This structure of payments enables the principal to minimize audit costs over the duration of the project. Those optimal contracts are such that the agent's expected income rises with time. Moreover, except in at most one period, the principal claims the entire returns of the project whenever audit occurs. We also provide conditions under which all optimal contracts must satisfy these properties. JEL Classification: D8; C7.

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 126.

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Length: 45 pages
Date of creation: Feb 2002
Date of revision:
Handle: RePEc:ecb:ecbwps:20020126

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Keywords: Dynamic contracts; theory of uncertainty and information; costly state verification; monitoring.;

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References

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  1. Thomas Cooley & Ramon Marimon & Vincenzo Quadrini, 2003. "Aggregate Consequences of Limited Contract Enforceability," NBER Working Papers 10132, National Bureau of Economic Research, Inc.
  2. 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.
  3. Chang, Chun, 1990. "The dynamic structure of optimal debt contracts," Journal of Economic Theory, Elsevier, vol. 52(1), pages 68-86, October.
  4. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated Insurance Relationships in a Costly State Verification Model: With an Application to Deposit Insurance," Staff General Research Papers 5194, Iowa State University, Department of Economics.
  5. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  6. 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).
  7. 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.
  8. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
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Cited by:
  1. Ravikumar, B & Zhang, Yuzhe, 2010. "Optimal auditing in a dynamic model of tax compliance," MPRA Paper 22924, University Library of Munich, Germany.
  2. 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.
  3. B. Ravikumar & Yuzhe Zhang, 2011. "Optimal auditing and insurance in a dynamic model of tax compliance," Working Papers 2011-020, Federal Reserve Bank of St. Louis.
  4. Langberg, Nisan, 2008. "Optimal financing for growth firms," Journal of Financial Intermediation, Elsevier, vol. 17(3), pages 379-406, July.
  5. Harold L. Cole, 2008. "Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims," PIER Working Paper Archive 08-025, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  6. Edward Simpson Prescott, 2004. "Auditing and bank capital regulation," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 47-63.

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