Collusion and Budget Distortions in Hierarchical Organizations

We reconsider Tirole’s (1986) framework of a three-tier principal/agent problem, in which he has argued that an additional incentive problem is caused by the possibility of collusion between the agent and the middle-level supervisor. We extend this basic model to allow for a variable size of the project to be carried out, and we assume that the supervisor has an interest in this size, thus incorporating an idea of the public-choice literature into a contract-theoretic analysis. It is shown that for incentive purposes, all variables of the optimal contract must be adjusted to reflect the supervisor’s concern for the budget, even though — in contrast to the public choice literature — he has no direct say over these variables. We conclude that in an asymmetric-information setting, an external effect on utility should be internalized through the optimal incentive contract.