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Optimal contracts in a dynamic costly state verification model

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  • Monnet, Cyril
  • Quintin, Erwan

Abstract

This paper describes optimal contracts in a dynamic costly state verification model with stochastic monitoring. An agent operates a risky project on behalf of a principal over several periods. Each period, the principal can observe the revenues from the project provided he incurs a fixed cost. We show that an optimal contract exists with the property that, in each period and for every possible revenue announcement by the agent, either the principal claims he entire proceeds from the project or promises to claim nothing in the future. This structure of payments enables the principal to minimize audit costs over the duration of the project. Those optimal contracts are such that the agent's expected income rises with time. Moreover, except in at most one period, the principal claims the entire returns of the project whenever audit occurs. We also provide conditions under which all optimal contracts must satisfy hese properties JEL Classification: D8, C7

Suggested Citation

  • Monnet, Cyril & Quintin, Erwan, 2002. "Optimal contracts in a dynamic costly state verification model," Working Paper Series 126, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2002126
    Note: 657474
    as

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    References listed on IDEAS

    as
    1. Chang, Chun, 1990. "The dynamic structure of optimal debt contracts," Journal of Economic Theory, Elsevier, vol. 52(1), pages 68-86, October.
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    More about this item

    Keywords

    Costly State Verification; Dynamic Contracts; Monitoring; Theory of Uncertainty and Information;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory

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