USING COST OBSERVATION TO REGULATE A MANAGER WHO HAS A PREFERENCE FOR EMPIRE‐BUILDING

We study regulation of a manager who has a preference for empire-building (high output), in the presence of moral hazard (unobservable effort) and adverse selection (unobservable productivity). We find that the optimal contract is linear in cost, being composed by a fixed payment plus a partial cost reimbursement. The preference for higher output reduces the manager's tendency to announce that his or her productivity is low, allowing a more powered incentive scheme (a lower fraction of the cost is reimbursed), which alleviates the problem of moral hazard.