Abstract
This article characterizes optimal policy when a government uses indirect control toexert its authority. Wedevelopadynamicprincipal-agent model inwhich a principal (a government) delegates thepreventionof a disturbance–suchas riots, protests, terrorism, crime, or tax evasion–to an agent who has an advantage in accomplishing this task. Our setting is a standard repeated moral hazard model with two additional features. First, the principal is allowed to exert direct control by intervening with an endogenously determined intensity of force which is costly to both players. Second, the principal suffers from limited commitment. Using recursive methods, we derive a fully analytical characterization of the intensity, likelihood, and duration of intervention. The first main insight from our model is that repeated and costly equilibrium interventions are a feature of optimal policy. This is because they are the most efficient credible means for the principal of providingincentives fortheagent. Thesecondmaininsight is adetailedanalysis of a fundamental trade-offbetween the intensity and duration of intervention which is drivenbytheprincipal’s inabilitytocommit. Finally, wederivesharppredictions regarding the impact of various factors on the optimal intensity, likelihood, and duration of intervention. We discuss these results in the context of some historical episodes.