Monitoring versus incentives

This paper analyzes the trade-off between monitoring and incentives in a principal-agent relationship with moral hazard. We derive general results on the optimal monitoring - incentives mix for the case where both parties are risk-neutral and the agent faces a limited liability constraint. We show that the principal uses less monitoring and stronger incentives if the agent's liability limit is relaxed or if monitoring costs increase. To induce more effort on the part of the agent, the principal resorts to more monitoring or to stronger incentives, or both. In particular, there are cases where the cheapest way to induce more effort is to use lower-powered money incentives, but with much more precise monitoring. (C) 2001 Elsevier Science B.V. All rights reserved.