SFB 303 Discussion Paper No. A - 550

Author: Kessler, Anke S.
Title: Optimal Monitoring in Hierarchical Relationships
Abstract: This paper studies a stylized three-layer agency framework in which a principal hires a supervisor to monitor the agent's productive effort. The principal has access to several monitoring technologies which differ in the quantity and the quality of the information they deliver. Three cases are distinguished. First, if the supervisor is honest it is demonstrated that the principal's expected return from the relationship is independent of the quantity of information the supervisor collects. The same result is shown to hold when the supervisor can collude with the agent but his report is "hard information", i.e. if the supervisor/agent coalition can only conceal but not falsify monitoring evidence. In both cases, the principal can achieve a first-best if the monitoring technology is sufficiently precise even though the supervisor and the agent are wealth-constrained and unbounded punishments are not feasible. Finally, if the supervisor's information is 'soft', the principal benefits both from the frequency and the accuracy of the supervisor's observations. This is the only case in which collusion imposes an additional cost on the principal. In addition, the findings suggest that it is strictly better for the principal to monitor the agent's action rather than testing for the unknown characteristics of the agent.
Keywords: Information Structure, Hierarchies, Collusion
JEL-Classification-Number: D82, L23
Creation-Date: January 1997
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