Optimal contracts with costly state verification : the multilateral case

48 Pages·1992·2.9 MB·English

by  Krasa, Stefan

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Faculty Working Paper 92-0101
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Optimal Contracts With Costly State
Verification: The Multilateral Case
i
FEB 1 / 1992
Stefan Krasa Anne P. Villamil
Department ofEconomics Department ofEconomics
University ofIllinois University ofIllinois
Bureau of Economic and Business Research
College of Commerce and Business Administration
University of Illinois at Urbana-Champaign

BEBR
FACULTY WORKING PAPER NO. 92-0101
College of Commerce and Business Administration
University of Illinois at Grbana-Champaign
January 1992
Optimal Contracts With Costly State
Verification: The Multilateral Case
Stefan Krasa
Anne P. Villamil
Department of Economics

Optimal Contracts With Costly State
Verification: The Multilateral Case
Stefan Krasa Anne P. Villamil*
First Draft: January 1991 This Draft: December 1991
Abstract
The purpose of this paper is to derive the structure of optimal
multilateral contracts in a costly state verification model with mul-
tiple agents who may be risk averse and need not be identical. We
consider'two different verification technology specifications. When the
verification technology is deterministic, we show that the optimal con-
tract is a multilateral debt contract in the sense that the monitoring
set is a lower interval. When the verification technology is stochastic,
we show that transfers and monitoring probabilities are decreasing
functions of wealth. The key economic problem in this environment
is that optimal contracts are interdependent. We are able to resolve
this externality problem using abstract measure theoretic tools.
"Address of the authors: Department of Economics, University of Illinois, 1206 South
Sixth Street, Champaign, IL 61820
We wish to thank Mark Feldman, Wayne Shafer and Nicholas Yannelis for useful com-
ments. We also gratefully acknowledge financial support from the National Science Foun-
dation (SES 89-09242).