DYNAMIC INCENTIVE CONTRACTS UNDER NO COMMITMENT TO PERIODIC AUDITING AND A RETROSPECTIVE PENALTY SYSTEM*

Hsiao‐chi Chen

Manchester School, 2006, vol. 74, issue 2, 190-213

Abstract: This study extends Khalil's (RAND Journal of Economics, Vol. 28 (1997), No. 4, pp. 629–640) model to a multiperiod one under no principal's commitment to periodic auditing and a retrospective penalty system. The optimal dynamic contracts may not exist. When they exist, there is no sure first‐period auditing and either the first‐best or a single contract is offered in the second period. The Khalil‐type (1997) and Baron–Myerson‐type (Econometrica, Vol. 50 (1982), No. 4, pp. 911–930) contracts could serve the first‐period contracts of the hybrid and separating equilibria, respectively. However, optimal dynamic contracts cannot be duplicated by these static contracts. Finally, players may prefer our pooling equilibrium to Laffont and Tirole's (European Economic Review, Vol. 31 (1987), No. 4, pp. 901–926). And the pooling equilibrium may weakly Pareto dominate the separating one.

Date: 2006
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