Abstract
This paper characterizes optimal policy when a government uses indirect control to exert its authority. We develop a dynamic principal-agent model in which a principal (a government) delegates the prevention of a disturbance — such as riots, protests, terrorism, crime, or tax evasion — to an agent who has an advantage in accomplishing this task. Our setting is a standard dynamic principal-agent 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 likelihood, intensity, and duration of intervention in the optimal contract. The first main insight from our model is that repeated and costly interventions are a feature of optimal policy. This is because they serve as a punishment to induce the agent into desired behavior. The second main insight is a detailed analysis of a fundamental tradeoff between the intensity and duration of intervention which is driven by the principal's inability to commit. Finally, we derive sharp predictions regarding the impact of various factors on the optimal likelihood, intensity, and duration of intervention. We discuss these results in the context of some historical episodes.
This is an electronic version of an article published in the Quarterly Journal of Economics 127 (2012): 947-1015