Costly monitoring, dynamic incentives, and default

Gaetano Antinolfi*, Francesco Carli

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

Abstract

We study dynamic contracts between a lender and a borrower in the presence of costly state verification and hidden effort. We prove three results. Costly monitoring is employed by the lender to optimally limit history dependence and prevent future inefficient termination of the relationship. Due to interaction between costly monitoring and dynamic incentives, the probability of monitoring may fail to be monotone in the borrower's reservation utility. Finally, following the interpretation of the costly state verification literature, we distinguish two levels of bankruptcy: one associated with restructuring and the other with liquidation.
Original languageEnglish
Pages (from-to)105-119
Number of pages15
JournalJournal of Economic Theory
Volume159
Issue numberPA
DOIs
Publication statusPublished - 1 Sep 2015

Keywords

  • Costly state verification
  • Default
  • Dynamic contracts
  • Monitoring
  • Moral hazard

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