Efficient Auditing and Enforcement in Dynamic Contracts

Private information and limited enforcement are two frictions that impede the provision of first best insurance against income risk. To mitigate these frictions, societies make costly investments into technologies such as auditing and enforcement systems. The implicit assumption throughout most of the literature is that either or both of these technologies is either costless or infinitely costly. I consider a model of efficient insurance in which at each point in time the principal can choose a level of enforceability that inhibits an agent's ability to renege on the contract and a level of auditing that inhibits his ability to conceal income. The dynamics of the optimal contract imply an endogenous lower bound on the lifetime utility of an agent, strictly positive auditing at all points in the contract and positive enforcement only when the agent's utility is sufficiently low. Furthermore, the two technologies operate as complements and substitutes at alternative points in the state space, uncovering dynamics that differ dramatically from the case in which the technologies are studied separately.