Working Paper: NBER ID: w14480
Authors: Harold L. Cole
Abstract: This paper studies the incentive issues associated with self-enforcing stochastic monitoring in a model of investment and production. The efficient contract features a debt-like payment with a threshold in terms of the reported output in which all of the reported output is taken up to the threshold if monitoring doesn't occur and all of the output is taken if monitoring does occur. An output report above the threshold leads to zero probability of monitoring and just the threshold amount being paid out. The efficiency gap between the self-enforcing contract and the commitment constraint is minimized when the monitors hold no part of the residual claim on the firm, which we associate with equity. Misreporting by the manager is an important component of the efficient contract.
Keywords: No keywords provided
JEL Codes: G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| self-enforcing stochastic monitoring (C54) | efficient contracts (D86) |
| structure of financial claims (G32) | efficiency of monitoring incentives (J33) |
| monitors do not hold residual claims (G33) | minimized efficiency gap between self-enforcing contract and commitment constraint (D86) |
| financial benefits from monitoring cover costs (J32) | monitoring efficiency (G14) |
| likelihood of misreporting (C83) | incentives for monitoring (M52) |
| stochastic monitoring exacerbates incentive problems (D82) | deterministic monitoring (C53) |
| nature of monitoring (E40) | reporting behavior of managers (M54) |