Authority, monitoring, and incentives in hierarchies

Abstract

We study three elements of management control: incentive compensation, performance monitoring, and delegation of authority to managers to contract with lower-level employees. Using a principal agent model, we highlight important direct and indirect interactions between and among these endogenous control elements, themes often emphasized in the economics and accounting literatures using the analogy of a three-legged stool. We identify circumstances in which control elements are complements or substitutes and exhibit a coherent pattern of practices observed together. For instance, contrary to typical predictions that quality monitoring complements steep effort incentives, we find that when contracting authority adjusts easily to changes in firm circumstances, then both incentive pay and contracting authority substitute for monitoring quality, while incentive pay complements contracting authority. Overall, our findings suggest a number of empirical implications and generally inform a growing literature that documents the presence or absence of complementarities among management control elements.