The Role of Bargaining Initiative Under no Commitment to Audit
| Author | A. Menichini |
| DOI | http://doi.org/10.1111/1467-9485.00200 |
| Published date | 01 August 2001 |
| Date | 01 August 2001 |
{Journals}sjpe/48_3/c161/makeup/c161.3d
THE ROLE OF BARGAINING INITIATIVE
UNDER NO COMMITMENT TO AUDIT
A. Menichini*
ABSTRACT
This paper addresses the issue of the optimal contract design under costly state
verification and no commitment to auditing when the contract offer comes from the
uninformed party. Contrary to similar frameworks and to cases where the informed
party retains the bargaining power, we find that the optimal contract is
characterised neither by truth telling nor by mixed strategy equilibria. Depending
on endogenous revenues and observation cost, a pooling equilibrium with either
deterministic or random auditing occurs.
II
NTRODUCTION
Many studies have focused on the form of the optimal principal-agent contract
when one of the parties has private information which is costly to verify
(Townsend, 1979; Gale and Hellwig, 1985; Mookherjee and Png, 1989). Much of
this literature assumes that the principal can credibly commit to an auditing
strategy, thus inducing truth-telling by the informed party. There is however, a
time inconsistency in the principal's behaviour because truth-telling itself can
induce potential ex-post incentive problems for the monitoring party. Starting
from this consideration, a new strand of literature has studied the form of the
optimal contract when the principal cannot commit to an audit strategy (Khalil,
1997; Khalil and Parigi, 1998; Menichini and Simmons, 1999; among others).
The common feature of this literature is to move away from the standard truth-
telling equilibrium typical of commitment contracts to get a mixed strategy
equilibrium where both the agent and the principal randomise in their reporting-
monitoring strategies, independently of who is the contract writer.
In this paper, using a costly state verification model with no commitment to
auditing and with limited liability, we examine the role of bargaining initiative in
defining the properties of the optimal contract and find that this can alter the
incentives of the agent to reveal the state of nature, thus also altering the
resulting welfare characteristics of the contract. Based on efficiency considera-
tions, most of the cited literature has assumed that the contract is offered by the
informed agent (Choe, 1998; Khalil and Parigi, 1998; Menichini and Simmons,
Scottish Journal of Political Economy,Vol.48,No.3,August2001
#Scottish Economic Society 2001,Publ ishedby Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and
350 Main Street, Malden, MA 02148, USA
303
*Universita
Ádi Salerno and University of York
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