American Economic Review: Vol. 99 No. 5 (December 2009)


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Endogenous Verifiability and Relational Contracting

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Kvaløy, Ola, and Trond E. Olsen. 2009. "Endogenous Verifiability and Relational Contracting." American Economic Review, 99(5): 2193-2208.

DOI: 10.1257/aer.99.5.2193


Principal-agent models usually invoke the strong assumption that the parties know for sure ex ante whether a variable is verifiable or not. This paper assumes 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. (JEL D82, D86)

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Kvaløy, Ola (U Stavanger)
Olsen, Trond E. (Norwegian School of Economics and Business Administration)

JEL Classifications

D82: Asymmetric and Private Information
D86: Economics of Contract: Theory

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