Moral Hazard and Private Monitoring

We analyze a model of repeated bilateral trade with moral hazard, where the quality of goods received can di er from the quality despatched due to deterioration during transportation. Since the sender does not observe the quality of good received and the receiver does not observe the quality despatched, we have a repeated game with with imperfect monitoring by private signals. The stage game has multiple Nash equilibria, which would allow cooperation in nitely repeated interaction. However, with private signals, the pure strategy equilibria of the twicerepeated game are degenerate, and cannot support any cooperation.We construct a mixed strategy equilibrium which supports partial cooperation. However this mixed strategy equilibrium cannot approximate the cooperative outcome even if the noise in the signals tends to zero. This failure of lower hemicontinuity in the sequential equilibrium correspondence is removed if we allow for extensive form correlation; i.e. we allow players to condition their second period actions upon a sunspot as well as the private signals. We use these ideas to show how e cient outcomes can be supported in in nitely repeated one-sided moral hazard.