Commitment vs. Flexibility with Costly Verification

57 Pages Posted: 19 Dec 2016 Last revised: 3 Mar 2024

See all articles by Marina Halac

Marina Halac

Columbia University

Pierre Yared

Columbia University - Columbia Business School, Finance

Multiple version iconThere are 2 versions of this paper

Date Written: December 2016

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

Halac, Marina and Yared, Pierre, Commitment vs. Flexibility with Costly Verification (December 2016). NBER Working Paper No. w22936, Available at SSRN: https://ssrn.com/abstract=2887198

Marina Halac (Contact Author)

Columbia University ( email )

Pierre Yared

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
Uris Hall
New York, NY 10027
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
23
Abstract Views
356
PlumX Metrics