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

David Martimort and Aggey Simons (Semenov)

No 26-1704, TSE Working Papers from Toulouse School of Economics (TSE)

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)
JEL-codes: C61 D82 D86 K12 (search for similar items in EconPapers)
Date: 2026-01-30, Revised 2026-08
New Economics Papers: this item is included in nep-des, nep-law, nep-mic and nep-reg
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Persistent link: https://EconPapers.repec.org/RePEc:tse:wpaper:131355

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