Incentive Provision when Contracting is Costly

We analyse optimal incentive contracts in a model where the probability of court enforcement is determined by the costs spent on contracting. The analysis shows that there is no monotonic relationship between contracting costs and incentive intensity, and that an increase in contracting costs may lead to higher‐powered incentives. Moreover, we formulate hypotheses about the relationship between legal systems and incentive provision. Specifically, the model predicts higher‐powered incentives in common law than in civil law systems. We also find that better performance measures may induce lower investments in contracting, and potentially lead to lower‐powered incentives.