Optimal Contracts under Costly State Falsification

Jeffrey Lacker and John Weinberg

Journal of Political Economy, 1989, vol. 97, issue 6, 1345-63

Abstract: We examine an exchange economy with two agents: one risk neutral with a certain endowment and a second risk averse with a random endowment. The realization of the endowment is public but can be falsified by the second agent at a cost. For a broad class of falsification cost functions the optimal no-falsification contract is noncontingent on a left-hand interval and strictly increasing with a slope strictly less than one on a right-hand interval. Under a mild further restriction, optimal no-falsification contracts are, in addition, piecewise linear. Optimal contracts may in general require falsifying the state, but for a set of the highest endowment realizations there is no falsification. We find simple conditions under which the optimal contract is a i no-falsification contract. Copyright 1989 by University of Chicago Press.

Date: 1989
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