A Theory of Supervision with Endogenous Transaction Costs

We propose a theory of supervision with endogenous transaction costs. A principal delegates part of his authority to a supervisor who can acquire soft information about an agent's productivity. If the supervisor were risk-neutral, the principal would simply make the better informed supervisor residual claimant for the hierarchy's profit. Under risk-aversion, the optimal contract trades-off the supervisor's incentives to reveal his information with an insurance motive. This contract can be identified with the one obtained in a simple hard information model of hierarchical collusion with exogenous transaction costs. Now, transaction costs are endogenous and depend on the collusion stake, the accuracy of the supervisory technology and the supervisor's degree of risk-aversion. We then discuss various implications of the model for the design and management of organizations.