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Endogenous Verifiability in Relational Contracting

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  • Kvaløy, Ola

    () (Norsk hotellhøgskole, Institutt for økonomi og ledelse, University of Stavanger)

  • Olsen, Trond E.

    () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

Abstract

We analyze a repeated principal-agent trust game where the principal makes a specific investment by paying the agent up-front, expecting an agreed upon quality level in return. The verifiability of the agent’s action is endogenously determined by the principal’s investment in writing an explicit contract. Since verification is not certain, explicit contracting is insufficient, and the parties must engage in relational (implicit) contracting. First, we analyze how variations in trust (the discount factor) affect the contract equilibrium. Interestingly, we find that more trust may lead to lower levels of specific investments. This occurs when the surplus from trust is realized mainly through lower explicit contract costs. Second, we extend the literature on the interaction between explicit and relational governance by analyzing how variations in verification technology affect contract equilibrium. Since verification technology determines the cost necessary to achieve a given probability of verification, this analysis can also explain interesting aspects of legal systems.

Suggested Citation

  • Kvaløy, Ola & Olsen, Trond E., 2004. "Endogenous Verifiability in Relational Contracting," Discussion Papers 2004/20, Norwegian School of Economics, Department of Business and Management Science.
  • Handle: RePEc:hhs:nhhfms:2004_020
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    File URL: http://hdl.handle.net/11250/163732
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    Keywords

    Trust; Relationship Specific Investments; Relational Contracts; Endogenous Verifiability;

    JEL classification:

    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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