Frequent Monitoring in Dynamic Contracts

Abstract

Workers do not directly observe their output in many organizational settings. Employers benefit from this, as a less informed worker is cheaper to motivate to repeatedly exert effort. In this environment, monitoring a worker's output is costly if it informs him of his own performance and, thus, induces fluctuations in his expected compensation. Monitoring, however, may be valuable as it improves immediate production decisions. This paper shows that the employee's past performance, and associated vested value in the firm, is critical in determining the optimal monitoring intensity. The supervisor monitors a poor-performing employee less to avoid demoralizing and having to fire him. Well-performing employees are closely monitored as their amassed promised compensation gives them a buffer against bad monitoring outcomes. The supervisor is lenient towards well-performing workers by correcting some of their mistakes without penalizing them, and even provides feedback and discrete bonuses after they do sufficiently well. By adjusting monitoring intensity and communication of performance, the principal can strategically defer the agent's pay-for-performance risk to states of the world when the termination costs are relatively low.

Keywords: repeated moral hazard, dynamic contracts, monitoring, communication, performance evaluations, interventions

JEL Classification: M52, J40