Fahad Khalil

Auditing Without Commitment

I study the optimal contract when a principal cannot commit to an audit. The contract must provide incentives for the agent to comply as well as for the principal to audit. The key tradeoff is efficiency versus noncompliance instead of the familiar rent versus efficiency. Information rent is zero whether production cost is high or low. For high production cost, the agent is asked to produce greater than the amount under full information. The probability of audit is higher when the principal cannot commit compared to when he can.

LOAN SIZE AS A COMMITMENT DEVICE

The authors model risky lending with costly state verification but without commitment to an audit strategy. The borrower underreports with a positive probability in the successful state and the lender audits with a positive probability after a report of failure. Under lack of commitment to audit probabilities, an increase in loan size convinces the borrower that the lender has a high stake in an audit. This reduces the probability of underreporting and leads to overinvestment relative to the commitment case. However, there is underinvestment relative to the level under full information. Copyright 1998 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Incentives for Corruptible Auditors in the Absence of Commitment

In the absence of commitment to auditing, we study the optimal auditing contract when collusion between an agent and an auditor is possible. We show that the auditor can be totally useless if the auditors independence can be compromised with relative ease. Even very stiff sanctions on fraud will be unable to make auditing optimal. We then derive a demand for independent external auditing. We endogenize collusion cost as the cost from the risk of future detection. We also derive a justification for the focus of the recent audit reforms on penalties on CEOs in cases of audit fraud.

Monitoring a Common Agent: Implications for Financial Contracting

We study the problem of multiple principals who want to obtain income from a privately informed agent and design their contracts non-cooperatively. Our analysis reveals that the degree of coordination between principals has strong implications for the shapes of contracts and the amount of monitoring. Equity-like contracts and excessive monitoring emerge when principals are able to coordinate monitoring or verify each others’ monitoring efforts. When this is not possible, free riding in monitoring weakens the incentive to monitor, so that flat payments, debt-like contracts and very low levels of monitoring appear. Free riding may be so strong that there may even be less monitoring than if the principals cooperated with each other, which shows that non-cooperative monitoring does not necessarily lead to excessive monitoring.

Gathering information before the contract is offered: The case with two states of nature

Abstract Focusing on a Baron-Myerson model with two states of nature, in the first part of the paper, we study the contract that a principal would offer to an agent when he does not know whether the agent is informed or not about the state of nature. In the second, we endogenize the information of acquisition, and show that in equilibrium a Baron-Myerson type contract will never be offered.

Catching the agent on the wrong foot: ex post choice of monitoring

Abstract In a principal-agent model with multiple performance measures, we show that the principal benefits by choosing ex post which variables will be monitored. If it is too costly for one type of agent to mimic all performance measures expected from another type, the principal can hope to catch the agent on the wrong foot if the agent tries to misrepresent his type. For cases of small asymmetry of information, the principal can implement the first best contract. For more serious asymmetries of information, the first best is not implementable. Then the low type may be required to overproduce, which is in contrast to the traditional result of second best contracting. We also obtain a ranking of monitoring instruments according to the frequency of their use.

Monitoring a Common Agent

We study the problem of multiple financiers who want to extract income from a privately informed agent and design their financial contracts non-cooperatively. Our analysis reveals that the degree of coordination between financiers has strong implications for the shapes of financial contracts. Equity like contracts and excessive monitoring emerge when principals are able to delegate monitoring or verify each others monitoring efforts. When this is not possible, free riding in monitoring weakens the incentive to monitor high profit levels, so that flat payments, debt-like contracts and very low levels of monitoring appear.

Contracts Offered by Bureaucrats

We examine the power of incentives in bureaucracies by studying contracts offered by a bureaucrat to her agent. The bureaucrat operates under a fixed budget, optimally chosen by a funding authority, and she can engage in policy drift, which we define as inversely related to her intrinsic motivation. Interaction between a fixed budget and policy drift results in low-powered incentives. We discuss how the bureaucrat may benefit from stricter accountability as it leads to larger budgets. Low-powered incentives remain even in an alternative centralized setting, where the funding authority contracts directly with the agent using the bureaucrat to monitor output.

Auctioneers as Market Makers: Managing Momentum in Chittagong Tea Auctions

In an auction market, the auctioneer exerts significant influence in choosing and administering a selling strategy. We make the case for viewing the auctioneer as a market maker, whose success depends on how well he manages externalities without jeopardizing the trust of the buyers and sellers. We illustrate that incentives of the market maker may not be aligned with that of individual sellers. Using a unique data set, from tea auctions in Chittagong, Bangladesh, we argue that an auctioneer’s actions maintain a careful balance of his own incentives vs. those of his clients, and the auction outcomes are affected by how much discretion the auctioneer has in choosing the selling strategy. Specifically, we find that raising the reserve price for a lot exerts a positive price externality on subsequent lots within the auction. To manage the momentum of market prices, the auctioneer chooses higher reserve prices for tea produced by tea estates in which he has an ownership stake. While these teas receive a higher price when sold, they sell less frequently creating a short run cost to the auctioneer but an overall positive impact on market prices. Thus, consistent with the role of a market maker, a desire to appear non-opportunistic, rather than opportunism, seems to better explain the auctioneer’s actions.