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Endogenous verifiability in relational contracting

Kvaløy, Ola; Olsen, Trond E.
Working paper
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kvaloy ola 2004.pdf (281.0Kb)
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http://hdl.handle.net/11250/163731
Utgivelsesdato
2004-11
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  • Discussion papers (FOR) [461]
Sammendrag
We analyze a repeated principal-agent trust game where the principal makes a specific investment by paying the agent up-front, expecting an agreed upon quality level in return. The verifiability of the agent’s action is endogenously determined by the principal’s investment in writing an explicit contract. Since verification is not certain, explicit contracting is insufficient, and the parties must engage in relational (implicit) contracting. First, we analyze how variations in trust (the discount factor) affect the contract equilibrium. Interestingly, we find that more trust may lead to lower levels of specific investments. This occurs when the surplus from trust is realized mainly through lower explicit contract costs. Second, we extend the literature on the interaction between explicit and relational governance by analyzing how variations in verification technology affect contract equilibrium. Since verification technology determines the cost necessary to achieve a given probability of verification, this analysis can also explain interesting aspects of legal systems.
Utgiver
Norwegian School of Economics and Business Administration. Department of Finance and Management Science
Serie
Discussion paper
2004:20

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