Optimal Contracts when Enforcement Is a Decision Variable

The 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 with limited commitment to payment and enforcement decisions. The paper shows that simple debt is the optimal contract when commitment is limited and costly enforcement is a decision variable. In contrast, stochastic contracts are optimal when agents can commit to the ex-ante optimal decisions. The paper also shows that the Costly State Verification model can be viewed as a reduced form of an enforcement model.