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Optimal audit policies with correlated types

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  • M. Boyer
  • Patrick González

Abstract

We propose a version of Townsend’s [17] model of costly audits where the agents’ types are correlated. Audits are used because agents have a limited ability to bear risk so that the Full Surplus Extraction (FSE) scheme á la Crémer and McLean [5,6] and McAfee and Reny [13] are suboptimal. It is shown that Townsend’s result is a special case of our model when agent types are uncorrelated. The performed numerical simulation of the model using two agents and two types offers interesting insights into what we call the Townsend Ridge. Indeed, the optimal contract which specifies wages to be paid and the audit strategy are remarkably different from one side of the ridge to the next. The observed discontinuity at the ridge reflects a discreet change from a single to a dual audit policy. Copyright Springer-Verlag Berlin/Heidelberg 2004

Suggested Citation

  • M. Boyer & Patrick González, 2004. "Optimal audit policies with correlated types," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 24(2), pages 325-334, August.
  • Handle: RePEc:spr:joecth:v:24:y:2004:i:2:p:325-334
    DOI: 10.1007/s00199-003-0435-7
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    Cited by:

    1. M. Martin Boyer & Patrick González, 2001. "Compensation and Auditing with Correlated Information," CIRANO Working Papers 2001s-59, CIRANO.
    2. M. Martin Boyer, 2004. "On the Use of Hierarchies to Complete Contracts when Players Have Limited Abilities," CIRANO Working Papers 2004s-41, CIRANO.

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