Manipulation and auditing of public sector contracts

We model purchaser-provider contracts when providers can inflate reimbursable activity through manipulation. Providers are audited and fined upon detected fraud. We characterise the optimal price and audit policy both in the presence and absence of commitment to an audit intensity. Under 'non-commitment' the audit intensity increases in reported activity, allowing the provider to soften it by reducing activity together with the underlying service quality and manipulation. The purchaser then faces a trade-off between offsetting this tendency by raising price and committing to a low audit intensity by reducing price. We identify circumstances under which the two forces balance out. (C) 2013 Elsevier B.V. All rights reserved.