Monday, December 17, 2012

How to monitor the monitor

Ann owns a restaurant. She hires Bob to tally the till every night and report back any mismatch between the till and that night’s bills. Ann is too busy to check the till herself and has to trust what Bob says. How can Ann provide Bob with appropriate incentives to exert the effort required to tally the till and report back the truth? ...

Some economists have emphasized auditing, perhaps at random to economize on its cost. Unfortunately, Ann is just too busy to tally the till herself—this option is not credibly available to her. ...

I propose that Ann can solve her problem by sometimes secretly taking money from the till and offering Bob the following deal: if Ann took some money, she will pay Bob only when he reports a mismatch; if Ann did not take any money, she will pay Bob only when a mismatch is not reported. Bob’s incentives are now aligned with Ann’s. If Bob doesn’t bother tallying the till, he won’t know what to tell Ann in order to make sure he gets paid. On the other hand, if he does his job he’ll discover whether or not there is a mismatch and deduce whether or not Ann took some money. Only then will Bob know what to tell Ann in order to get paid. By asking Bob a “trick question,” Ann can now rest assured that he will acquire the requisite costly information and reveal it truthfully.
--David Rahman, American Economic Review, on better living through contract theory