Optimal Stationary Contracts under One-Sided Enforcement and Persistent Adverse Selection

David Martimort () and Aggey Simons ()
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David Martimort: Toulouse School of Economics, France
Aggey Simons: Department of Economics, University of Ottawa, Canada
Authors registered in the RePEc Author Service: Aggey Semenov

No 2603E, Working Papers from University of Ottawa, Department of Economics

Abstract: We characterize the optimal contract within the class of stationary mechanisms in a repeated buyer-seller relationship with persistent adverse selection and one-sided limited enforcement. A prepaid seller may breach after receiving the current transfer and terminate the relationship upon paying an enforceable penalty. In this stationary 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, public penalties alone cannot sustain compliance, and the principal must leave 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)
Pages: 23 pages
Date: 2026
New Economics Papers: this item is included in nep-des, nep-law and nep-reg
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