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Optimal contracts in a dynamic costly state verification model

  • Cyril Monnet


  • Erwan Quintin


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 who can observe the project’s revenues at a cost. We show that an optimal contract exists such that, at any history, either the principal claims the project’s entire revenues or promises to claim nothing in the future. In particular, the agent’s expected income rises with time. Moreover, except in at most one period, the principal claims all revenues when audit occurs. We provide conditions under which all optimal contracts satisfy these properties. Copyright Springer-Verlag Berlin/Heidelberg 2005

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Article provided by Springer in its journal Economic Theory.

Volume (Year): 26 (2005)
Issue (Month): 4 (November)
Pages: 867-885

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Handle: RePEc:spr:joecth:v:26:y:2005:i:4:p:867-885
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  1. 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).
  2. Chang, Chun, 1990. "The dynamic structure of optimal debt contracts," Journal of Economic Theory, Elsevier, vol. 52(1), pages 68-86, October.
  3. 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.
  4. Williamson, Stephen D, 1987. "Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 102(1), pages 135-45, February.
  5. Thomas Cooley & Ramon Marimon & Vicenzo Quadrini, 1999. "Aggregate consequences of limited contract enforceability," Economics Working Papers 843, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2003.
  6. Bruce D. Smith & Cheng Wang, 1997. "Repeated insurance relationships in a costly state verification model: with an application to deposit insurance," Working Papers 574, Federal Reserve Bank of Minneapolis.
  7. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  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.
  9. 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.
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