Penalizing Shirking in Discovering Unsuitability
-
Ying Xue
and
Xu Jiang
Abstract
We study the optimal penalty scheme for an expert firm and a layman client against shirking in their costly interaction that helps the firm discover the unsuitable transaction, i.e. one that yields a loss for the client. The market solution to the bilateral hidden action problem fails to incentivize sufficient effort and leads to an inefficient outcome, which creates scope for government action. By contrast, private contracts obtain efficiency in an alternative framework with just the firm’s unilateral effort, highlighting the role of the client’s effort in rationalizing legal intervention. Under the unique first-best policy, the firm not only refunds the client but also pays the client’s loss to the government if the firm fails to stop a transaction that ends up being unsuitable. The client receives the refund but submits the firm’s production cost to the government. The optimal punitive penalty is their total contingent loss and is robust to private contracts. The optimal penalty generalizes to a multi-agent team by making each agent internalize all others’ contingent losses.
Appendix: Unilateral Effort
This appendix presents the optimal penalty without considering the client’s effort, which is qualitatively different from the full model in the main text. Specifically, the firm can restore efficiency by fully compensating the client, which involves no punitive penalty and can thus be implemented by the firm’s private contract with the client. Therefore, the client’s hidden action in the firm’s discovery of the unsuitable transaction rationalizes legal intervention.
To see what difference the client’s effort makes, we remove his effort e and effort cost c(e) from the full model, so that the firm detects unsuitability with probability f(a), which is increasing in a with f(0) = 0. The social welfare in (5) becomes
The first-best
by adopting the maintained assumption that w(a*, 1, 0) > 0. The firm’s surplus in (12) becomes
Consider x = l. The firm chooses 1 l = 0 at t = 5 since its coefficient is negative. Suppose the firm is in business and chooses 1 g = 1 at t = 5. Then its surplus reduces to
The firm chooses its effort a at t = 4 to solve
which is equivalent to the first-best problem for a* that maximizes the social welfare in (34). The firm thus exerts efficient effort.
The firm’s direct compensation to the client without the government’s intervention can be represented as y = −x in our notation as if the government merely passes the firm’s payment to the client. Given the firm’s choice of (1 g , 1 l ) = (1, 0) and x = l, the client’s surplus without his effort is
The equilibrium price is p l,−l = g because the firm fully insures the client and extracts his surplus. The firm chooses 1 g = 1 to stay in business since its resulting surplus from (36) when p = g and a = a* is w(a*, 1, 0) > 0. When no effort is needed from the client, private solutions restore efficiency and legal intervention is unnecessary.
Proposition 7
If no effort is needed from the client, then the firm restores efficiency by fully insuring the client, so that the equilibrium price is the good outcome g.
Private contracts can attain efficiency when sorting involves just unilateral effort and private information. Our bilateral hidden action framework is therefore pivotal for rationalizing legal intervention in practice for the purpose of restoring efficiency, even if the client’s effort may be less important or costly than the firm’s effort. Our theory predicts that punitive laws tend to govern and benefit markets where both the firm’s and the client’s efforts are needed for the firm to identify potential unsuitability.
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Articles in the same Issue
- Frontmatter
- Articles
- Should Courts Decide Climate Policies?
- On the Role of Courts in Climate Policy: Comment on Lando
- Origins of the Economic Approach to Crime and Punishment
- Are Individual Care Investments Affected by Past Accident Experiences?
- Penalizing Shirking in Discovering Unsuitability
- The Disavowal of Decisionism: Politically Motivated Exits from the U.S. Courts of Appeals
Articles in the same Issue
- Frontmatter
- Articles
- Should Courts Decide Climate Policies?
- On the Role of Courts in Climate Policy: Comment on Lando
- Origins of the Economic Approach to Crime and Punishment
- Are Individual Care Investments Affected by Past Accident Experiences?
- Penalizing Shirking in Discovering Unsuitability
- The Disavowal of Decisionism: Politically Motivated Exits from the U.S. Courts of Appeals
