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Costly Verification of Cost Performance and the Competition for Incentive Contracts

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  • Stephanie A. Dunne
  • Mark A. Loewenstein

Abstract

This article analyzes the optimal linear incentive contract to offer to would-be agents competing for a principal's project when the principal finds it costly to observe an agent's cost performance ex post and cannot commit to monitoring policy ex ante. Cost sharing reduces the winning bidder's informational rents but creates an incentive for the agent to pad costs ex post to slacken his effort. The optimal cost-sharing parameter generally differs from that when monitoring is costless, and it is higher the fewer the number of bidders and the larger the variance of their idiosyncratic cost.

Suggested Citation

  • Stephanie A. Dunne & Mark A. Loewenstein, 1995. "Costly Verification of Cost Performance and the Competition for Incentive Contracts," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 690-703, Winter.
    • Handle: RePEc:rje:randje:v:26:y:1995:i:winter:p:690-703
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    Citations

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    Cited by:

    1. Andrea Cattaneo, 2003. "The Pursuit of Efficiency and Its Unintended Consequences: Contract Withdrawals in the Environmental Quality Incentives Program," Review of Agricultural Economics, Agricultural and Applied Economics Association, vol. 25(2), pages 449-469.
    2. Finkle, Aaron & Shin, Dongsoo, 2007. "Conducting inaccurate audits to commit to the audit policy," International Journal of Industrial Organization, Elsevier, vol. 25(2), pages 379-389, April.
    3. Gifford, Sharon, 1999. "Efficient moral hazard," Journal of Economic Behavior & Organization, Elsevier, vol. 40(4), pages 427-442, December.
    4. Martin Pollrich, 2017. "Mediated audits," RAND Journal of Economics, RAND Corporation, vol. 48(1), pages 44-68, March.
    5. Rohit Patel & Can Urgun, 2021. "Costly Inspection and Money Burning in Internal Capital Markets," Working Papers 2021-29, Princeton University. Economics Department..
    6. Aaron Finkle, "undated". "Obstructive Monitoring," Working Papers 14-05, Davidson College, Department of Economics.
    7. François MARECHAL & Michel MOUGEOT, 2004. "Risk sharing and moral hazard under prospective payment to hospitals: how to reimburse services for outlier patients," Cahiers de Recherches Economiques du Département d'économie 04.03, Université de Lausanne, Faculté des HEC, Département d’économie.
    8. Aaron Finkle & Dongsoo Shin, 2020. "Obstructive monitoring," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 29(4), pages 873-891, October.
    9. Annamaria Menichini & Peter Simmons, 2001. "Are two investors better than one?," CSEF Working Papers 71, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

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