Endogenous Verifiability and Relational Contracting

Abstract

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.

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.