The B.E. Journal of Theoretical Economics
Editor-in-Chief: Schipper, Burkhard
Ed. by Fong, Yuk-fai / Peeters, Ronald / Puzzello , Daniela / Rivas, Javier / Wenzelburger, Jan
IMPACT FACTOR 2017: 0.220
5-year IMPACT FACTOR: 0.328
CiteScore 2017: 0.28
SCImago Journal Rank (SJR) 2017: 0.181
Source Normalized Impact per Paper (SNIP) 2017: 0.459
Mathematical Citation Quotient (MCQ) 2017: 0.09
Liars and Inspectors: Optimal Financial Contracts When Monitoring is Non-Observable
Within a costly state verification setting, we derive the optimal financial contract between an entrepreneur, a (potentially financing) supervisor and a pure investor when there is non-verifiable and non-contractible monitoring and limited liability. We show that diversion of cash flows to the entrepreneur arises as optimal behaviour and that to get the best reporting and monitoring incentives it is crucial to separate the financing from the monitoring role. In particular, higher efficiency can be achieved by ensuring that the entrepreneur and the supervisor do not collect any cash flows in low states. These should be paid to a third party instead, the pure investor, who in exchange provides funding. However, whether the pure investor entirely finances the project (and the supervisor purely acts as a monitor) or only provides partial finance (with the supervisor cofinancing) is immaterial, as the optimal financing of the project can justify a range of alternative financial structures.
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