Partial monitoring, adverse selection, and the internal efficiency of the firm

Abstract

The paper investigates an adverse selection model with monitoring of managerial effort. In contrast to the literature, we assume that the manager can be punished only if his effort is below a certain level that is monitored by the principal. Surprisingly, the optimal labor contract may induce an equilibrium effort which is lower than in the standard model without monitoring. This result holds for any discrete distribution of managerial types. In the continuous type case, the optimal contracts for high-quality (low-quality) managers are purely output-dependent (effort-dependent).