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…)