Endogenous Verifiability and Optimality in Agency

This paper investigates the optimal contract design in a principal-agent model where verification of an agent's action is endogenously determined through strategic interactions between contracting parties. We derive a necessary and sufficient condition for the first best outcome to be implemented as an equilibrium. The equilibrium has the following features: (i) The action level that the agent chooses is not verified even if it is possible. (ii) Nevertheless, the first best can be attained by making a contract contingent on the unverified action. Journal of Economic Literature Classification Numbers: D20, K40.