Contract design and costly verification games

In this paper, the signalling subgame in costly verification models is studied in the context of the investor-entrepreneur contract without assuming the possibility of commitment to verification. It is shown that the game has a unique Perfect Bayesian Equilibrium in mixed strategies, implying that truth-telling and deterministic verification are not an equilibrium behavior. When the entire game starting from the stage of contract design is considered, it is shown that the contract designed by the informed entrepreneur results in less verification cost than the one designed by the uninformed investor. This could be taken as a normative criterion based upon which institutional arrangements as regards the distribution of bargaining initiative are to be designed.