Endogenous Verifiability and Relational Contracting

37 Pages Posted: 17 May 2005 Last revised: 5 Feb 2008

See all articles by Ola Kvaloy

Ola Kvaloy

University of Stavanger

Trond E. Olsen

Norwegian School of Economics (NHH) - Department of Business and Management Science; CESifo (Center for Economic Studies and Ifo Institute)

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

Kvaloy, Ola and Olsen, Trond E., Endogenous Verifiability and Relational Contracting (January 2008). Available at SSRN: https://ssrn.com/abstract=721861 or http://dx.doi.org/10.2139/ssrn.721861

Ola Kvaloy (Contact Author)

University of Stavanger ( email )

N-4036 Stavanger
Norway

Trond E. Olsen

Norwegian School of Economics (NHH) - Department of Business and Management Science ( email )

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N-5045 Bergen
Norway
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