Optimal Contracts with a Utility-Maximizing Auditor

Abstract

This paper presents a principal-agent model in which the agent becomes strictly better informed than the principal after the contract agreement. To mitigate the inefficiency caused by this information asymmetry, the principal and agent agree that the agent will communicate the private information to the principal.' They can further reduce this inefficiency by hiring a utility-maximizing auditor, whose effort is not observable, to attest to the validity of the agent's message. To improve efficiency with this attestation, the principal must -motivate the auditor to audit effectively and to report honestly. Thus, hiring a utility-maximizing auditor to mitigate the inefficiency in the principal-agent contractual relationship may introduce a moral hazard problem and a new source of inefficiency. Our objectives are (a) to characterize an optimal pair of contracts (principal-agent and principal-auditor) so as (b) to analyze both how