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Moral Hazard with Counterfeit Signals

In many moral hazard problems, the principal evaluates the agent's performance based on signals which the agent may suppress and replace with counterfeits. This form of fraud may affect the design of optimal contracts drastically, leading to complete market failure in extreme cases. I show that in optimal contracts, the principal deters all fraud, and does so by two complementary mechanisms. First, the principal punishes signals that are suspicious, i.e. appear counterfeit. Second, the principal is lenient on bad signals that the agent could suppress, but does not.

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Paper provided by Edinburgh School of Economics, University of Edinburgh in its series ESE Discussion Papers with number 225.

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Length: 39
Date of creation: 13 Jun 2013
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Handle: RePEc:edn:esedps:225
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  1. Bull, Jesse & Watson, Joel, 2007. "Hard evidence and mechanism design," Games and Economic Behavior, Elsevier, vol. 58(1), pages 75-93, January.
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