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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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    Cited by:

    1. Matthias Lang, 2012. "Communicating Subjective Evaluations," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2012_14, Max Planck Institute for Research on Collective Goods, revised Apr 2017.
    2. Sloof, Randolph & Sonnemans, Joep, 2011. "The interaction between explicit and relational incentives: An experiment," Games and Economic Behavior, Elsevier, vol. 73(2), pages 573-594.
    3. Engelseth, Per, 2016. "Aligning end-to-end seafood supply through a series of markets," International Journal of Production Economics, Elsevier, vol. 173(C), pages 99-110.
    4. Hideshi Itoh & Hodaka Morita, 2015. "Formal Contracts, Relational Contracts, and the Threat-Point Effect," American Economic Journal: Microeconomics, American Economic Association, vol. 7(3), pages 318-346, August.
    5. Tore Ellingsen & Eirik Gaard Kristiansen, 2011. "Financial Contracting Under Imperfect Enforcement," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 323-371.
    6. Panu Poutvaara & Tuomas Takalo & Andreas Wagener, 2017. "The Optimal Duration of Contracts," CESifo Working Paper Series 6808, CESifo Group Munich.
    7. Fabrice Lumineau & Bertrand Quélin, 2012. "An empirical investigation of interorganizational opportunism and contracting mechanisms," Post-Print hal-00668599, HAL.
    8. Kvaløy, Ola & Olsen, Trond E., 2015. "The tenuous relationship between effort and performance pay," Journal of Public Economics, Elsevier, vol. 121(C), pages 32-39.
    9. Wu, Steven Y., 2013. "Adapting Contract Theory to Fit Contract Farming," 2014 Allied Social Science Association (ASSA) Annual Meeting, January 3-5, 2014, Philadelphia, PA 161894, Agricultural and Applied Economics Association.
    10. Giacomo Calzolari & Leonardo Felli & Johannes Koenen & Giancarlo Spagnolo & Konrad O. Stahl, 2015. "Trust, Competition and Innovation: Theory and Evidence from German Car Manufacturers," CESifo Working Paper Series 5229, CESifo Group Munich.
    11. David Martimort & Aggey Semenov & Lars Stole, 2017. "A Theory of Contracts with Limited Enforcement," Review of Economic Studies, Oxford University Press, vol. 84(2), pages 816-852.
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    15. Bohdan Kukharskyy & Michael Pflüger, 2011. "Relational Contracts and the Economic Well-Being of Nations," Working Papers 095, Bavarian Graduate Program in Economics (BGPE).
    16. Jean Beuve & Stéphane Saussier, 2012. "Interfirm cooperation in strategic relationships: the role of formal contract," Industrial and Corporate Change, Oxford University Press, vol. 21(4), pages 811-836, August.
    17. James M. Malcomson, 2012. "Relational Incentive Contracts," Introductory Chapters,in: Robert Gibbons & John Roberts (ed.), The Handbook of Organizational Economics Princeton University Press.
    18. Manuel Willington & Roy Costilla, 2007. "Endogenous Verifiability and Optimality in Agency: A non-contingent approach," ILADES-Georgetown University Working Papers inv189, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
    19. Chen, Bo, 2012. "All-or-nothing payments," Journal of Mathematical Economics, Elsevier, vol. 48(3), pages 133-142.
    20. Kukharskyy, Bohdan, 2015. "Relational contracts and global sourcing," University of Tuebingen Working Papers in Economics and Finance 83, University of Tuebingen, Faculty of Economics and Social Sciences.
    21. Hyytinen, Ari & Steen, Frode & Toivanen, Otto, 2012. "Anatomy of Cartel Contracts," Discussion Paper Series in Economics 25/2012, Norwegian School of Economics, Department of Economics.
    22. Ola Kvaløy & Trond E. Olsen, 2016. "Incentive Provision when Contracting is Costly," Economica, London School of Economics and Political Science, vol. 83(332), pages 741-767, October.
    23. Hermalin, Benjamin E. & Li, Larry & Naughton, Tony, 2013. "The relational underpinnings of formal contracting and the welfare consequences of legal system improvement," Economics Letters, Elsevier, vol. 119(1), pages 72-76.
    24. Bohdan Kukharskyy, 2012. "Quality of Institutions, Global Sourcing, and the Make-or-Buy Decision," Working Papers 128, Bavarian Graduate Program in Economics (BGPE).

    More about this item

    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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