Scandinavian Working Papers in Business Administration

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2010/10: Incentive provision when contracting is costly

Ola Kvaløy and Trond E. Olsen ()
Additional contact information
Ola Kvaløy: Dept. of Economics and Business Administration, University of Stavanger, Postal: University of Stavanger , N-4036 Stavanger, Norway
Trond E. Olsen: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: We analyze optimal incentive contracts in a model where the probability of court enforcement is determined by the costs spent on contracting. We show that contract costs matter for incentive provision, both in static spot contracts and repeated game relational contracts. We find that social surplus may be higher under costly relational contracting than under costless verifiable contracting, and show that there is not a monotonic relationship between contracting costs and incentive intensity. In particular we show that an increase in contracting costs may lead to higher-powered incentives. Moreover we formulate hypotheses about the relationship between legal systems and incentive provision, specifically the model predicts higher-powered incentives in common law than in civil law systems.

Keywords: Contract costs; incentive provision

JEL-codes: J00

34 pages, August 31, 2010

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