Abstract: We study a continuous-time agency model, where the principal hires a manager to operate the business. Because the manager controls the cash flow rate of the project via hidden effort, a conflict of interest arises.
The necessary incentives are provided through both performance based compensation and monitoring by an intermediary, whose monitoring activity is also subject to moral hazard. We analyze two different ways to resolve these agency conflicts, ‘delegated monitoring’ and ‘delegated investment’. In the first scenario, the principal can provide the optimal level of incentives to both, intermediary and manager. In the second scenario, the principal offers a contract only to the intermediary, who in turn designs the contract for the manager. Consequently, the principal must motivate the intermediary to monitor the manager’s activities as well as to provide the right menu to him.
We find that incentives react differently to performance in these two cases. Whereas strong performance optimally shifts incentives from the manager to the intermediary under ‘delegated monitoring’, it triggers higher incentives for both agents under ‘delegated investment’. As a methodological contribution, we propose a novel, tractable framework to analyze multidimensional moral hazard, that can be applied in various fields, including corporate finance, labour and health economics.
joint work with Sebastian Gryglewicz.