Optimal audit policies with correlated types

Summary. We propose a version of Townsends 17] model of costly audits where the agents types are correlated. Audits are used because agents have a limited ability to bear risk so that the Full Surplus Extraction (FSE) scheme á la Crémer and McLean 5,6] and McAfee and Reny 13] are suboptimal. It is shown that Townsends result is a special case of our model when agent types are uncorrelated. The performed numerical simulation of the model using two agents and two types offers interesting insights into what we call the Townsend Ridge. Indeed, the optimal contract which specifies wages to be paid and the audit strategy are remarkably different from one side of the ridge to the next. The observed discontinuity at the ridge reflects a discreet change from a single to a dual audit policy.Received: 11 November 2002, Revised: 10 September 2003JEL Classification Numbers: C63, D82.Correspondence to: M. Martin BoyerWe wish to thank seminar participants at the CEA-Toronto, SCSE-Montréal and WCES-Seattle meetings for discussions and comments on an earlier version of the paper, as well as an anonymous referee for this journal. This paper was financially supported by an Emerging Scholar grant from the American Compensation Association, and by the Fonds FCAR-Québec. The continuing financial support of CIRANO is also appreciated. We remain responsible for any error.