CONTRACT DESIGN AND COSTLY VERIFICATION GAMES

In this paper, the signalling subgame in costly verification models is studied in the context of the investor-entrepreneur contract without assuming the possibility of commitment to verification. It is shown th at the game has a unique Perfect Bayesian Equilibrium in mixed strateg ies, implying that truth-telling and deterministic verification are no t an equilibrium behavior. When the entire game starting from the stag e of contract design is considered, it is shown that the contract desi gned by the informed entrepreneur results in less verification cost th an the one designed by the uninformed investor. This could be taken as a normative criterion based upon which institutional arrangements as regards the distribution of bargaining initiative an to be designed. ( C) 1998 Elsevier Science B.V.