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Limited commitment and costly enforcement

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  • Jeffrey M. Lacker

Abstract

A costly 'facility' has a monopoly on the ability to coerce transfers and verify all private information. If invoked, the facility reads instructions recorded ex ante, and carries out the contingent transfers among agents, charging agents for the cost. Agents agree ex ante to a set of recorded instructions to the facility, and then play a sequential game without commitment. A basic two-agent insurance environment serves as an application throughout. When both agents have full information the costs and limitations of the facility constrain the set of attainable allocations, even though the facility is never invoked in equilibrium. When there is private information, the model can be viewed as a reformulation of the standard costly-auditing model, but the incentive constraints are significantly more severe. Pure strategy optimal contracts are debt contracts, as in Townsend (1979), but mixed strategy optimal contracts cannot be ruled out in general. An extension shows that if costs vary with the realized state in a particular way, debt contracts as in Williamson (1987) can be optimal, even allowing for mixed strategies.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 90-02.

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Date of creation: 1989
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Handle: RePEc:fip:fedrwp:90-02

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Keywords: Contracts;

References

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  1. Shavell, Steven, 1984. "The Design of Contracts and Remedies for Breach," The Quarterly Journal of Economics, MIT Press, vol. 99(1), pages 121-48, February.
  2. Lacker, J.M., 1989. "Optimal Contracts Under Costly State Falsification," Purdue University Economics Working Papers 956, Purdue University, Department of Economics.
  3. Reinganum, Jennifer F. & Wilde, Louis L., 1985. "Income tax compliance in a principal-agent framework," Journal of Public Economics, Elsevier, vol. 26(1), pages 1-18, February.
  4. Edward C Prescott & Robert M Townsend, 2010. "Pareto Optima and Competitive Equilibria With Adverse Selection and Moral Hazard," Levine's Working Paper Archive 2069, David K. Levine.
  5. Drew Fudenberg & Jean Tirole, 1988. "Moral Hazard and Renegotiation in Agency Contracts," Working papers 494, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Nahum D. Melumad & Dilip Mookherjee, 1989. "Delegation as Commitment: The Case of Income Tax Audits," RAND Journal of Economics, The RAND Corporation, vol. 20(2), pages 139-163, Summer.
  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. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  9. Lane, Frederic C., 1958. "Economic Consequences of Organized Violence," The Journal of Economic History, Cambridge University Press, vol. 18(04), pages 401-417, December.
  10. Steven Shavell, 1980. "Damage Measures for Breach of Contract," Bell Journal of Economics, The RAND Corporation, vol. 11(2), pages 466-490, Autumn.
  11. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
  12. Huberman, Gur & Kahn, Charles M, 1988. "Limited Contract Enforcement and Strategic Renegotiation," American Economic Review, American Economic Association, vol. 78(3), pages 471-84, June.
  13. Townsend, Robert M., 1988. "Information constrained insurance : The revelation principle extended," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 411-450.
  14. Ronald A. Dye, 1986. "Optimal Monitoring Policies in Agencies," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 339-350, Autumn.
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Cited by:
  1. Edward S. Prescott, 1999. "A primer on moral-hazard models," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 47-78.
  2. Persons, John C., 1997. "Liars Never Prosper? How Management Misrepresentation Reduces Monitoring Costs," Journal of Financial Intermediation, Elsevier, vol. 6(4), pages 269-306, October.
  3. Jeffrey Lacker, 2001. "Collateralized Debt as the Optimal Contract," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 842-859, October.

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