Costly state verification with Limited Commitment

Abstract

This paper examines a principal-agent model that the princi-pal mandates actions and conducts costly inspections without transfers. The principal prefers lower actions, while the agent prefers higher ac-tions and has private information about his type. The agent is protected by ex-post participation and rejects any action below his private type. The principal faces a trade-off between mandating lower actions and the risk the the agent rejects actions and chooses his outside option. We analyze various levels of the principal’s commitment ability. If the principal can commit to both inspections and actions when no inspec-tion is performed, and if the principal’s fear of ruin is greater than the agent’s, then a deterministic inspection policy is optimal. Additionally, if the principal cannot commit to either inspections or actions, the highest equilibrium payoff does not involve non-deterministic inspec-tion strategies. Finally, if the inspection cost is low and the principal commits to inspecting whenever requested by the agent, the principal can achieve the payoff of the optimal deterministic inspection policy..

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Reference

Amirreza Ahmadzadeh, “Costly state verification with Limited Commitment”, TSE Working Paper, n. 24-1570, September 2024.