Optimal supervision with moral hazard

Abstract

This paper adopts the principal–supervisor–agent hierarchy model pioneered by Tirole [Tirole, J., 1986. Hierarchies and bureaucracies: on the role of collusion in organizations. Journal of Law, Economics and Organization 2, 181–214] to analyze the optimal architecture of supervision. We consider a principal who encounters a double moral hazard problem. In particular, we examine the endogenously determined supervisory effort and the possibility of untruthful revelation of supervisor's message. The degree of accuracy for this endogenously chosen information architecture hinges upon the supervisory technology, the supervisor's reservation utility and the agent's production technology. Besides, though the principal's welfare would be lowered when the possibility of untruthful revelation is taken into account, we find that his desired supervisory effort level may be enhanced instead.