On the Use of Loose Monitoring and Lavish Pay in Agency

Abstract

In this paper, we study a setting where a firm (principal) is privately informed of the firm's potential and contracts with an agent to supply unobservable effort. We show it can be optimal for the firm to have loose monitoring in the sense that the monitoring system is less perfect than what is implied by a standard agency model a la Holmstrom (1979) and to provide lavish pay in the sense that the optimal contract provides the agent with higher expected utility than his reservation level. These two tools are used to achieve separation among different types of firms such that firms with low potential do not have incentives to mimic contracts offered by high potential firms. Our findings imply that although loose monitoring and lavish compensation offered to employees may be symptoms of firms squandering scarce resources provided by investors, they can also arise as an optimal contracting arrangement.

Keywords: Performance measure, lavish pay, information system, loose monitoring, conservatism

JEL Classification: M40, M41, M46, J33, G34, D82, B21