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Costly monitoring, dynamic incentives, and default

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  • Antinolfi, Gaetano
  • Carli, Francesco

Abstract

We study dynamic contracts between a lender and a borrower in the presence of costly state verification and hidden effort. We prove three results. Costly monitoring is employed by the lender to optimally limit history dependence and prevent future inefficient termination of the relationship. Due to interaction between costly monitoring and dynamic incentives, the probability of monitoring may fail to be monotone in the borrower's reservation utility. Finally, following the interpretation of the costly state verification literature, we distinguish two levels of bankruptcy: one associated with restructuring and the other with liquidation.

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  • Antinolfi, Gaetano & Carli, Francesco, 2015. "Costly monitoring, dynamic incentives, and default," Journal of Economic Theory, Elsevier, vol. 159(PA), pages 105-119.
    • Handle: RePEc:eee:jetheo:v:159:y:2015:i:pa:p:105-119
    DOI: 10.1016/j.jet.2015.05.011
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    Cited by:

    1. Borys Grochulski & Russell Wong, 2018. "Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization," Working Paper 18-17, Federal Reserve Bank of Richmond.
    2. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    3. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    4. Achim, Peter & Knoepfle, Jan, 0. "Relational enforcement," Theoretical Economics, Econometric Society.
    5. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated insurance relationships in a costly state verification model: With an application to deposit insurance," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 207-240, July.

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    More about this item

    Keywords

    Costly state verification; Default; Monitoring; Dynamic contracts; Moral hazard;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General

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