Monitoring and Subcontracting Arrangement with a Collusive Supervisor

Abstract

This paper investigates the optimal performance evaluation scheme of a supervisor who monitors a worker in a setting where the worker can collude with the supervisor. We study the setting where the supervisor's incentive problem results from collusion, not from work aversion. In the owner-supervisor-worker structure, the supervisor monitors the worker's effort and reports to the owner. The owner evaluates the worker based on the supervisor's report and imposes less risk on the worker, saving the risk premium to him. To prevent collusion between the supervisor and the worker, the owner must hold the supervisor responsible for the worker's performance, paying risk premium to the supervisor. Examples show that the owner prefers the owner-supervisor-worker structure to the owner-worker structure when the worker is very risk averse relative to the supervisor. Examples also show that if the supervisor and the worker can make side transfers for risk sharing as well as for collusion, the owner might prefer the owner-supervisor-worker structure only when the supervisor's risk aversion is neither too great nor too small. When the supervisor is close to risk neutral, either his limited liability or high reservation utility makes it too costly to hire him. The subcontracting structure where the supervisor is delegated to contract with the worker is shown to be performance equivalent to the owner-supervisor-worker structure. In the subcontracting, the supervisor's direct control on the worker's compensation plays the same role that the supervisor's report does in the three-tier hierarchy.