Commitment vs. Flexibility with Costly Verification

Marina Halac and Pierre Yared

No 22936, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We introduce costly verification into a general delegation framework. A principal faces an agent who is better informed about the efficient action but biased towards higher actions. An audit verifies the agent’s information, but is costly. The principal chooses a permissible action set as a function of the audit decision and result. We show that if the audit cost is small enough, a threshold with an escape clause (TEC) is optimal: the agent can select any action up to a threshold, or request audit and the efficient action if the threshold is sufficiently binding. For higher audit costs, the principal may instead prefer auditing only intermediate actions. However, if the principal cannot commit to inefficient allocations following the audit decision and result, TEC is always optimal. Our results provide a theoretical foundation for the use of TEC in practice, including in capital budgeting in organizations, fiscal policy, and consumption-savings problems.

JEL-codes: D02 D82 D86 E02 (search for similar items in EconPapers)
Date: 2016-12
New Economics Papers: this item is included in nep-acc, nep-mac and nep-mic
Note: EFG IO POL
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Citations: View citations in EconPapers (1)

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Working Paper: Commitment vs. Flexibility with Costly Verification (2018)
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