USING COST OBSERVATION TO REGULATE A MANAGER WHO HAS A PREFERENCE FOR EMPIRE‐BUILDING

Ana Borges () and João Correia‐da‐silva
Authors registered in the RePEc Author Service: Joao Correia-da-Silva

Manchester School, 2011, vol. 79, issue 1, 29-44

Abstract: We study regulation of a manager who has a preference for empire-building (high output), in the presence of moral hazard (unobservable effort) and adverse selection (unobservable productivity). We find that the optimal contract is linear in cost, being composed by a fixed payment plus a partial cost reimbursement. The preference for higher output reduces the manager's tendency to announce that his or her productivity is low, allowing a more powered incentive scheme (a lower fraction of the cost is reimbursed), which alleviates the problem of moral hazard.

Date: 2011
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