The Impact of Verifiability on Contracts

Abstract

We analyze the impact of verifiability on how signals about agents are used to mitigate adverse selection. We show that if signals are verifiable the observed practice of collecting information about agents before contracting is inferior to writing contingent contracts. This holds regardless of the agent's risk aversion, bounded penalties, or investigation costs. In fact, with risk-neutral agents, a principal can get first-best utility with contingent contracts. We further show that even unverifiable signals can be gainfully used in contingent contracts by removing a principal's incentives to distort signals or by removing an agent's incentives to demand verification.