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Commitment vs. Flexibility with Costly Verification

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  • Marina Halac
  • Pierre Yared

Abstract

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.

Suggested Citation

  • Marina Halac & Pierre Yared, 2016. "Commitment vs. Flexibility with Costly Verification," NBER Working Papers 22936, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:22936
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    References listed on IDEAS

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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.
    2. Strausz, Roland, 2003. "Deterministic mechanisms and the revelation principle," Economics Letters, Elsevier, vol. 79(3), pages 333-337, June.
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    JEL classification:

    • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy

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