Harmful monitoring

Abstract

Abstract We show that there may be circumstances in which a principal prefers not to observe the project choice of an agent that acts on her behalf. The ability of the agent is private information. Projects differ with respect to the amount of risk. If the principal can observe the project choice of the agent, the latter will use that choice as a signal. In the separating equilibrium, an agent with high ability then chooses a project that is too risky. If more difficult projects require more effort, there are two opposite effects. The shirking effect implies that the agent chooses a project that is too safe. The signaling effect implies that he chooses a project that is too risky. The net effect is ambiguous. We also discuss the implications of our model for promotion policies.