Random Inspections and Periodic Reviews: Optimal Dynamic Monitoring

74 Pages Posted: 25 Jan 2017 Last revised: 26 May 2018

See all articles by Felipe Varas

Felipe Varas

Duke University - Fuqua School of Business - Finance Department

Ivan Marinovic

Graduate School of Business, Stanford University

Andrzej Skrzypacz

Stanford University - Stanford Graduate School of Business

Date Written: November 2, 2017

Abstract

This paper studies the design of monitoring policies in dynamic settings with moral hazard. The firm benefits from having a reputation for quality, and the principal can learn the firm’s quality by conducting costly inspections. Monitoring plays two roles: An incentive role, because the outcome of inspections affects the firm’s reputation, and an informational role because the principal values the information about the firm’s quality. We characterize the optimal monitoring policy inducing full effort. The optimal policy is simple, being either deterministic, random with a constant hazard rate, or a mixture of them.

Keywords: Monitoring, Auditing, Dynamic Contracts, Dynamic Games, Reputation

JEL Classification: C73, D82, D83, D84

Suggested Citation

Varas, Felipe and Marinovic, Ivan and Skrzypacz, Andrzej, Random Inspections and Periodic Reviews: Optimal Dynamic Monitoring (November 2, 2017). Stanford University Graduate School of Business Research Paper No. 17-9. Available at SSRN: https://ssrn.com/abstract=2905756 or http://dx.doi.org/10.2139/ssrn.2905756

Felipe Varas (Contact Author)

Duke University - Fuqua School of Business - Finance Department ( email )

Durham, NC 27708-0120
United States

Ivan Marinovic

Graduate School of Business, Stanford University ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Andrzej Skrzypacz

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-0987 (Phone)
650-725-9932 (Fax)

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