Random Inspections and Periodic Reviews: Optimal Dynamic Monitoring
74 Pages Posted: 25 Jan 2017 Last revised: 26 May 2018
Date Written: November 2, 2017
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: Suggested Citation