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Optimal Contracts in a Dynamic Costly State Verification Model

45 Pages Posted: 20 Feb 2002  

Cyril Monnet

Federal Reserve Bank of Philadelphia

Erwan Quintin

Federal Reserve Bank of Dallas

Date Written: February 2002

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 the 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 these properties.

Keywords: Dynamic Contracts, Theory of Uncertainty and Information, Costly State Verification, Monitoring

JEL Classification: D8, C7

Suggested Citation

Monnet, Cyril and Quintin, Erwan, Optimal Contracts in a Dynamic Costly State Verification Model (February 2002). ECB Working Paper No. 126. Available at SSRN: https://ssrn.com/abstract=299542

Cyril Monnet (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Erwan Quintin

Federal Reserve Bank of Dallas ( email )

PO Box 655906
Dallas, TX 75265-5906
United States

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