In any organization, individuals can shirk by taking advantage of the fact that their actions are private; only a stochastic signal of effort can be observed, for instance. Because of this, firms and governments hire monitors to watch, imperfectly, what workers are doing, and to punish the workers if it is believed that the workers are taking actions contrary to what the bosses desire. Even if the monitor observed signals that are not available to the bosses, as long as that observation is free, the monitor has no incentive to lie. But what if monitoring is costly? How can we ensure the monitor has the right incentives to do his job? That is, who shall monitor the monitor? The answer, clearly, isn’t a third level of monitors, since this just pushes the problem back one more level.
In a very interesting new paper, David Rahman extends Holmstrom’s (who should share the next Nobel with Milgrom; it’s nuts they both haven’t won yet!) group incentives. The idea of group incentives is simple, and it works when monitor’s statements are verifiable. Say it costs 1 to monitor and the agent’s disutility from work is also 1. The principle doesn’t mind an equilibrium of (monitor, work), but better would be the equilibrium (don’t monitor, work), since then I don’t need to pay a monitor to watch my workers. The worker will just shirk if no one watches him, though. Group penalties fix this. Tell the monitor to check only one percent of the time. If he reports (verifiably) that the worker shirked, nobody gets paid. If he reports (verifiably) that the worker worked, the monitor gets $1.02 and the worker gets $100. By increasing the payment to the worker for “good news”, the firm can get arbitrarily close to the payoffs from the “never monitor, work” equilibrium.
That’s all well and good, but what about when the monitor’s reports are not verifiable? In that case, the monitor would never actually check but would just report that the worker worked, and the worker would always shirk. We can use the same idea as in Holmstrom, though, and sometimes ask the worker to shirk. Make payments still have group penalties, but pay the workers only when the report matches the recommended action – that is, pay for “monitor/shirk” and “monitor/work”. For the same reason as in the above example, the frequency of monitoring and shirking can both be made arbitrarily small, with the contract still incentive compatible (assuming risk neutrality, of course).
More generally, a nice use of the Minimax theorem shows that we check for deviations from the bosses’ recommended actions for the monitor and the agent one by one – that is, we needn’t check for all deviations simultaneously. So-called “detectable” deviations are shut down by contracts like the one in the example above. Undetectable deviations by the monitor still fulfill the monitoring role – by virtue of being undetectable, the agent won’t notice the deviation either – but it turns out that finiteness of the action space is enough to save us from an infinite regress of profitable undetectable deviations, and therefore a strategy like the one in the example above does allow for “almost” optimal costly and unverifiable monitoring.
Two quick notes: First, collusion, as Rahman notes, can clearly take place in this model (each agent just tells the other when he is told to monitor or to shirk), so it really speaks only to situations where we don’t expect such collusion. Second, this model is quite nice because it clarifies, again, that monitoring power needn’t be vested in a principal. That is, the monitor here collects no residual profits or anything of that sort – he is merely a “security guard”. Separating the monitoring role of agents in a firm from the management role is particularly important when we talk about more complex organizational forms, and I think it’s clear that the question of how to do so is far from being completely answered.
http://www.econ.umn.edu/~dmr/monitor.pdf (WP – currently R&R at AER and presumably will wind up there…)
A Fine Theorem 
I’ve worked in a consumer finance company as part of the fraud detection team, before deciding a phd in economics would give me greater utility.
Now, I know that the “agent has disutility from work” assumption is fairly common in the principal-agent literature. But, might I say, this is not quite apt?
My boss for instance loved to figure out which of our “agents” – and we were “agents” to our common “superboss” – was committing fraudulent accounts to our dataset. In fact, the reason I quit was I did not enjoy the work. In fact, think of why you like a job or not.
It is because you get utility from working, not disutility. Most people do not work for the salary they receive (unless you’re a day-labourer in which case the disutility from work assumption is valid).
For most (or at least, some) jobs in a capitalist country – barring a few – I am not sure this “disutility from working” idea is a valid one. After all, the “American Dream” is all about doing what you want…and at least by the imperfect indicator of GDP it seems to have worked. I guess one could go into the GDP versus happiness debate but that is really beside the point.
Two responses. First, many people “like their job”, but few would volunteer to do it, I imagine. I don’t think the disutility assumption is that crazy.
Second, the disutility is mechanism models isn’t necessarily about working, per se. It’s about encouraging the “right” level of work in some sense. That is, even when people like their job, it’s still usually possible to motivate higher levels of effort through financial means, right?
well, ask yourself, when people talk of motivation, it’s usually something internal, dedicated to something non-monetary. In some ways, a monetary payment can be seen as repulsive. Some of the labour econ career models get at this notion.
I don’t know what you mean when you say people get utility from something but they wouldn’t volunteer to do it. There is an implicit assumption that people like to be lazy. But I disagree. Most of us – given the fact that we are choosing do something of our own free will – prefer to be engaged actively at some level at least, if this is something we like.
I also believe the idea of the right kind of effort in the sense of producing something meaningful except for the more banal tasks will never be known, this is a situation of Knigthian uncertainty, so if this is accepted then the argument that disutility is a motivation for generating the right effort will break down.
I suspect some Williamson type thinking is needed to get at this; Robert Gibbons argues in a recent paper that too little attempt has been made to take Williamson’s labour econ type writings seriously. With all these information theoretic tools at our fingertips the time is ripe.
[…] related to those in Rahman’s excellent “Who will Monitor the Monitor?” which was discussed on this site four years […]
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