The Impact of Verifiability on Contracts

We show how the verifiability of signals affects their use in mitigating adverse selection. With verifiable signals, the observed practice of investigating agents before contracting is inferior to writing contingent contracts. This holds regardless of the agentʹs risk aversion, bounded penalties, or investigation costs. With risk-neutral agents, contingent contracts yield first-best outcomes. We further show that even unverifiable signals can be gainfully used in contingent contracts by removing a principalʹs incentives to distort signals or by removing an agentʹs incentives to demand verification.