Penalizing Shirking in Discovering Unsuitability

We study the optimal penalty scheme for an expert firm and a layman client against shirking in their costly interaction that helps the firm discover the unsuitable transaction, i.e. one that yields a loss for the client. The market solution to the bilateral hidden action problem fails to incentivize sufficient effort and leads to an inefficient outcome, which creates scope for government action. By contrast, private contracts obtain efficiency in an alternative framework with just the firm’s unilateral effort, highlighting the role of the client’s effort in rationalizing legal intervention. Under the unique first-best policy, the firm not only refunds the client but also pays the client’s loss to the government if the firm fails to stop a transaction that ends up being unsuitable. The client receives the refund but submits the firm’s production cost to the government. The optimal punitive penalty is their total contingent loss and is robust to private contracts. The optimal penalty generalizes to a multi-agent team by making each agent internalize all others’ contingent losses.