Endogenous Verifiability and Relational Contracting

Principal-agent models usually invoke the strong assumption that the parties know ex ante for sure whether a variable is verifiable or not. In this paper we assume that only the probability of verification is known, and that this probability is endogenously determined. We analyze a principal-agent relationship where the verifiability of the agent's output is determined by the principal's investment in drafting an explicit contract. The model is well suited for analyzing the relationship between explicit contracting, legal courts, trust and relational contracting. In particular we show how trust - established through repeated interaction - and legal courts may induce contractual incompleteness and lower the level of relationship specific investments