Optimal contracts in a dynamic costly state verification model

Summary. This paper describes optimal contracts in a dynamic costly state verification model with stochastic monitoring. An agent operates a risky project on behalf of a principal who can observe the projects revenues at a cost. We show that an optimal contract exists such that, at any history, either the principal claims the projects entire revenues or promises to claim nothing in the future. In particular, the agents expected income rises with time. Moreover, except in at most one period, the principal claims all revenues when audit occurs. We provide conditions under which all optimal contracts satisfy these properties.Received: 4 February 2004, Revised: 4 June 2004, JEL Classification Numbers: D8, C7. Correspondence to: Cyril MonnetWe wish to thank Patrick Bolton, Vitor Gaspar, Mark Guzman, Martin Hellwig, Narayana Kocherlakota, Thorsten Koeppl, Albert Marcet, Benny Moldovanu, Ernst-Ludwig von Thadden and seminar participants at the University of Mannheim, the University of Minnesota, the Society for Economics Dynamics Meetings in New York and the Society for the Advancement in Economic Theory in Rhodos for helpful comments and discussions. The views expressed herein are those of the authors and may not reflect the views of the European Central Bank, the Eurosystem, the Federal Reserve Bank of Dallas or the Federal Reserve System.