Endogenous Verifiability and Relational Contracting
37 Pages Posted: 17 May 2005 Last revised: 5 Feb 2008
Date Written: January 2008
Abstract
Principal-agent models usually invoke the strong assumption that the parties know ex ante for sure whether a variable is verifiable or not. In this paper we assume that only the probability of verification is known, and that this probability is endogenously determined. We analyze a principal-agent relationship where the verifiability of the agent's output is determined by the principal's investment in drafting an explicit contract. The model is well suited for analyzing the relationship between explicit contracting, legal courts, trust and relational contracting. In particular we show how trust - established through repeated interaction - and legal courts may induce contractual incompleteness and lower the level of relationship specific investments.
Keywords: Relational Contracts, Endogenous Verifiability, Courts, Contract Law, Trust
JEL Classification: D86, K12, L14
Suggested Citation: Suggested Citation
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