Endogenous Verifiability in Relational Contracting

Ola Kvaløy and Trond Olsen

No 2004/20, Discussion Papers from Norwegian School of Economics, Department of Business and Management Science

Abstract: We analyze a repeated principal-agent trust game where the principal makes a specific investment by paying the agent up-front, expecting an agreed upon quality level in return. The verifiability of the agent’s action is endogenously determined by the principal’s investment in writing an explicit contract. Since verification is not certain, explicit contracting is insufficient, and the parties must engage in relational (implicit) contracting. First, we analyze how variations in trust (the discount factor) affect the contract equilibrium. Interestingly, we find that more trust may lead to lower levels of specific investments. This occurs when the surplus from trust is realized mainly through lower explicit contract costs. Second, we extend the literature on the interaction between explicit and relational governance by analyzing how variations in verification technology affect contract equilibrium. Since verification technology determines the cost necessary to achieve a given probability of verification, this analysis can also explain interesting aspects of legal systems.

Keywords: Trust; Relationship Specific Investments; Relational Contracts; Endogenous Verifiability (search for similar items in EconPapers)
JEL-codes: J41 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2004-12-29
New Economics Papers: this item is included in nep-soc
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Journal Article: Endogenous Verifiability and Relational Contracting (2009)
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