Optimal Fixed-Terms Contracts under One-Sided Enforcement and Persistent Adverse Selection

David Martimort and Aggey Semenov
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David Martimort: TSE-R - Toulouse School of Economics - UT Capitole - Université Toulouse Capitole - Comue de Toulouse - Communauté d'universités et établissements de Toulouse - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, IUF - Institut universitaire de France - M.E.N.E.S.R. - Ministère de l'Education nationale, de l’Enseignement supérieur et de la Recherche
Aggey Semenov: uOttawa - Université d'Ottawa = University of Ottawa [Ontario]

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Abstract: We characterize the optimal contract within the class of fixed-terms mechanisms in a repeated buyer-seller relationship with persistent adverse selection and one-sided limited enforcement. The seller reports his type once, and the corresponding transfer and output are then repeated in every period. After receiving the current transfer, the seller may breach, pay an enforceable penalty, and terminate the relationship. In this benchmark, the enforcement problem collapses to a bound on the transfer targeted to the most efficient type. This yields a three-regime characterization. With strong enforcement, the repeated static second-best contract is feasible. With weak (intermediate) enforcement, the top transfer is capped, inducing bunching among efficient types and additional downward distortions. With very weak enforcement, sustaining compliance through public penalties alone would require excessive quantity distortions, and the optimal contract instead leaves strictly positive continuation rents, including for the least efficient type. We interpret the associated distortion as a virtual enforcement cost.

Keywords: Adverse selection; Limited enforcement; Relational contracts; Contract breach (search for similar items in EconPapers)
Date: 2026-10
New Economics Papers: this item is included in nep-com, nep-des and nep-mic
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Published in Journal of Mathematical Economics, 2026, 126, pp.103294. ⟨10.1016/j.jmateco.2026.103294⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-05742834

DOI: 10.1016/j.jmateco.2026.103294

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