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Monitoring versus Incentives: Substitutes or Complements?

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Abstract

This paper analyzes the trade-off between monitoring and incentives in a principal-agent relationship with moral hazard. We derive general results on the optimal monitoring-incentives mix for the case where both parties are risk-neutral and the agent faces a limited liability constraint. We show that the prinicpal uses less monitoring and stronger incentives if the agent's liability limit is relaxed or if monitoring costs increase. To induce more effort on the part of the agent, the principal resorts to more monitoring or to stronger incentives, or both. In particular, there are cases where the cheapest way to induce more effort is to use lower powered incentives, but with much more precise monitoring. Cet article analyse l'arbitrage entre la vérification et l'incitation dans un modèle de principal-agent caract´risé par du risque moral. Nous dérivons des résultats généraux pour le cas où les deux participants sont neutres aux risques et l'agent fait face à une contrainte budgétaire. Il est montré que le principal utilisera moins de vérifications et des incitations plus fortes si la contrainte budgétaire est relaxée ou si les coûts de vérification augmentent. Pous inciter plus d'efforts de la part de l'agent, il est montré que le principal pourrait utiliser soit plus de vérifications, soit plus d'incitations, soit plus des deux. En particulier, il est possible que la methode la moins coûteuse soit de réduire les incitants et de surcompenser en augmentant la précision et la vérification.

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Bibliographic Info

Paper provided by CREFE, Université du Québec à Montréal in its series Cahiers de recherche CREFE / CREFE Working Papers with number 47.

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Length: 25 pages
Date of creation: Mar 1997
Date of revision:
Publication status: forthcoming in the European Economic Review
Handle: RePEc:cre:crefwp:47

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Related research

Keywords: moral hazard; principal-agent; limited liability; information systems;

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References

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  1. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 53(6), pages 1357-67, November.
  2. Baron, David P & Besanko, David, 1988. " Monitoring of Performance in Organizational Contracting: The Case of Defense Procurement," Scandinavian Journal of Economics, Wiley Blackwell, vol. 90(3), pages 329-56.
  3. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
  4. Lafontaine, Francine & Slade, Margaret E., 1996. "Retail contracting and costly monitoring: Theory and evidence," European Economic Review, Elsevier, vol. 40(3-5), pages 923-932, April.
  5. Cremer, Jacques, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 275-95, May.
  6. Kim, Son Ku, 1995. "Efficiency of an Information System in an Agency Model," Econometrica, Econometric Society, vol. 63(1), pages 89-102, January.
  7. Dominique M. Demougin & Devon A. Garvie, 1991. "Contractual Design with Correlated Information under Limited Liability," RAND Journal of Economics, The RAND Corporation, vol. 22(4), pages 477-489, Winter.
  8. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
  9. Dominique Demougin & Claude Fluet, 1998. "Mechanism Sufficient Statistic in the Risk-Neutral Agency Problem," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 154(4), pages 622-, December.
  10. Steven Shavell, 2003. "Economic Analysis of Accident Law," NBER Working Papers 9483, National Bureau of Economic Research, Inc.
  11. McAfee, R Preston & Reny, Philip J, 1992. "Correlated Information and Mechanism Design," Econometrica, Econometric Society, vol. 60(2), pages 395-421, March.
  12. Holmstrom, Bengt & Milgrom, Paul, 1994. "The Firm as an Incentive System," American Economic Review, American Economic Association, vol. 84(4), pages 972-91, September.
  13. Park, Eun-Soo, 1995. "Incentive Contracting under Limited Liability," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(3), pages 477-90, Fall.
  14. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-44, June.
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Cited by:
  1. Eberhard Feess, 1999. "Lender Liability for Environmental Harm: An Argument Against Negligence Based Rules," European Journal of Law and Economics, Springer, vol. 8(3), pages 231-250, November.

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