Dynamic Contracting with Flexible Monitoring

Abstract

We study a dynamic contracting problem in which the principal can allocate his limited capacity between seeking evidence that confirms or that contradicts the agent's effort, as the basis for reward or punishment. Such flexibility calls for jointly designed monitoring and compensation schemes practically relevant but novel in the literature. When the agent's continuation value is low, the principal seeks only confirmatory evidence, but when the agent's continuation value exceeds a threshold, the principal switches to seeking mainly contradictory evidence. Moreover, the agent's effort can be perpetuated if and only if both synergy and flexibility in monitoring are sufficiently large.