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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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  • Dominique Demougin & Claude Fluet, 1997. "Monitoring versus Incentives: Substitutes or Complements?," Cahiers de recherche CREFE / CREFE Working Papers 47, CREFE, Université du Québec à Montréal.
  • Handle: RePEc:cre:crefwp:47
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    References listed on IDEAS

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    1. 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.
    2. 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 622-622, December.
    3. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 53(6), pages 1357-1367, November.
    4. Steven Shavell, 2003. "Economic Analysis of Accident Law," NBER Working Papers 9483, National Bureau of Economic Research, Inc.
    5. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
    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. Holmstrom, Bengt & Milgrom, Paul, 1994. "The Firm as an Incentive System," American Economic Review, American Economic Association, vol. 84(4), pages 972-991, September.
    8. Jacques Crémer, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, Oxford University Press, vol. 110(2), pages 275-295.
    9. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-444, June.
    10. 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 329-356.
    11. McAfee, R Preston & Reny, Philip J, 1992. "Correlated Information and Mechanism Design," Econometrica, Econometric Society, vol. 60(2), pages 395-421, March.
    12. Park, Eun-Soo, 1995. "Incentive Contracting under Limited Liability," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(3), pages 477-490, Fall.
    13. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
    14. 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.
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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.

    More about this item

    Keywords

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

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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