Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2004/20: Endogenous Verifiability in Relational Contracting

Ola Kvaløy () and Trond E. Olsen ()
Additional contact information
Ola Kvaløy: Norsk hotellhøgskole, Institutt for økonomi og ledelse, University of Stavanger, Postal: University of Stavanger, 4036 Stavanger, Norway
Trond E. Olsen: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: We analyze a repeated principal-agent trust game where the principal makes a specific investment by paying the agent up-front, expecting an agreed upon quality level in return. The verifiability of the agent’s action is endogenously determined by the principal’s investment in writing an explicit contract. Since verification is not certain, explicit contracting is insufficient, and the parties must engage in relational (implicit) contracting. First, we analyze how variations in trust (the discount factor) affect the contract equilibrium. Interestingly, we find that more trust may lead to lower levels of specific investments. This occurs when the surplus from trust is realized mainly through lower explicit contract costs. Second, we extend the literature on the interaction between explicit and relational governance by analyzing how variations in verification technology affect contract equilibrium. Since verification technology determines the cost necessary to achieve a given probability of verification, this analysis can also explain interesting aspects of legal systems.

Keywords: Trust; Relationship Specific Investments; Relational Contracts; Endogenous Verifiability

JEL-codes: J41

28 pages, December 29, 2004

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