Incentive design in three level hierarchies under moral hazard

Official URL: http://risc01.sabanciuniv.edu/record=b1819799 (Table of Contents)

This thesis studies the incentives in multi-level hierarchical institutions under moral hazard. The principal’s objective is to induce the agent exert “high” effort and a supervisor is used to monitor either the agent’s effort or the output level. We extend a canonical agent-supervisor-principal model by introducing ex-ante collusion possibilities, whereby the parties can side-contract before execution of the official contract, that is, before the supervisor and the agent incur their respective inspection and effort costs. The thesis characterizes least-cost incentive contracts with and without ex-ante and ex-post collusion possibilities. It is shown that preventing only ex-ante, or only ex-post, collusion does not prevent the other automatically: the two collusion-proofness constraints are independent. Second, when full collusion possibilities are incorporated, the only constraint that can be ignored is the supervisor’s incentive compatibility constraint (implied by ex-ante collusion prevention). Third, it is shown that safeguarding against ex-ante collusion raises the principal’s expected costs, in some cases “significantly”. We discuss the effectiveness of preventing all types of collusion and show that despite of increases in expected costs, the principal still finds preventing all types of collusions optimal. Finally, we show that input monitoring is structurally more efficient than output monitoring. If the same given monitoring technology is available and equally effective in generating hard evidence, the supervisor should assess the effort level of the agent and not the final output