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Costly Monitoring, Dynamic Incentives, and Default

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  • Gaetano Antinolfi

    (Washington University)

Abstract
We study dynamic contracts between a lender and a borrower in the presence of costly state verification and hidden effort. The optimal contract minimizes social losses by mediating dynamic incentives and monitoring. Along the efficiency frontier, the threat of early termination is unavoidable for low levels of the borrower's promised utility; as the level increases, preventive monitoring is used to avoid future inefficient termination of the contractual relationship due to asymmetric information; for high level of promised utility, the threat of termination of the contractual relationship is no longer a useful tool to align dynamic incentives, preventive monitoring loses its role, and termination never occurs. Thus, the efficient contract optimizes the tradeoff between dynamic incentives and static incentives. Following the interpretation of the costly state verification literature, we can distinguish two levels of bankruptcy: one that leads to monitoring and the other that leads to liquidation.

Suggested Citation

  • Gaetano Antinolfi, 2012. "Costly Monitoring, Dynamic Incentives, and Default," 2012 Meeting Papers 892, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:892
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    References listed on IDEAS

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    Cited by:

    1. Borys Grochulski & Russell Wong, 2018. "Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization," Working Paper 18-17, Federal Reserve Bank of Richmond.
    2. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    3. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    4. Achim, Peter & Knoepfle, Jan, 2024. "Relational enforcement," Theoretical Economics, Econometric Society, vol. 19(2), May.
    5. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated insurance relationships in a costly state verification model: With an application to deposit insurance," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 207-240, July.

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    More about this item

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General

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