Dynamic contracts with random monitoring

Abstract

In contractual relationships where the agent executes numerous independent tasks over the lifetime of the contract, it is often infeasible to evaluate his performance on all tasks that he is assigned. Incentives under moral hazard are instead provided by randomly determining whether or not to monitor each of these tasks. We characterize optimal contracts implemented with such random monitoring in a stochastic dynamic environment where the agent’s cost type varies over time. We show that the compensation terms the agent is promised for contingencies where monitoring reveals compliance are as good as those for when no monitoring takes place, and for some cost types are better; these latter types receive a monitoring reward. As time passes and the agent becomes richer, the size of the monitoring reward decreases. Compensation on the equilibrium path exhibits downward rigidity, a feature elicited empirically by earlier literature.