Optimal Contracts When Enforcement is a Decision Variable

This paper analyzes choice-theoretic costly enforcement in an intertemporal contracting model with a differentially informed investor and entrepreneur. An intertemporal contract is modeled as a mechanism is which there is limited commitment to payment and enforcement decisions. The goal of the analysis is to characterize the effect of choice-theoretic costly enforcement on the structure of optimal contracts. The paper shows that simple debt is the optimal contract when commitment is limited and costly enforcement is a decision-variable (Theorem 1). In contrast, stochastic contracts are optimal when agents can commit to the ex-ante optimal decisions (Theorem 2). The paper also shows that the Costly State Verification model can be viewed as a reduced form of an enforcement model in which agents chose payments and strategies as part of a Perfect Bayesian Nash Equilibrium