Commitment vs. Flexibility with Costly Verification
We introduce costly verification into a general delegation framework. A principal faces an agent who is better informed about the efficient action but biased towards higher actions. An audit verifies the agent’s information, but is costly. The principal chooses a permissible action set as a function of the audit decision and result. We show that if the audit cost is small enough, a threshold with an escape clause (TEC) is optimal: the agent can select any action up to a threshold, or request audit and the efficient action if the threshold is sufficiently binding. For higher audit costs, the principal may instead prefer auditing only intermediate actions. However, if the principal cannot commit to inefficient allocations following the audit decision and result, TEC is always optimal. Our results provide a theoretical foundation for the use of TEC in practice, including in capital budgeting in organizations, fiscal policy, and consumption-savings problems.
|Date of creation:||Dec 2016|
|Note:||EFG IO POL|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
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- Bull, Jesse & Watson, Joel, 2007.
"Hard evidence and mechanism design,"
Games and Economic Behavior,
Elsevier, vol. 58(1), pages 75-93, January.
- Bull, Jesse & Watson, Joel, 2002. "Hard Evidence and Mechanism Design," University of California at San Diego, Economics Working Paper Series qt7715f08f, Department of Economics, UC San Diego.
- Watson, Joel & Bull, Jesse, 2006. "Hard Evidence and Mechanism Design," University of California at San Diego, Economics Working Paper Series qt7973v805, Department of Economics, UC San Diego.
- Joel Watson & Jesse Bull, 2004. "Hard Evidence and Mechanism Design," Econometric Society 2004 North American Winter Meetings 433, Econometric Society.
- Strausz, Roland, 2003. "Deterministic mechanisms and the revelation principle," Economics Letters, Elsevier, vol. 79(3), pages 333-337, June. Full references (including those not matched with items on IDEAS)
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