To Trust or Monitor: A Dynamic Analysis

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Conference Paper

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In a principal-agent framework, principals can mitigate moral hazard problems not only through extrinsic incentives such as monitoring, but also through agents' intrinsic trustworthiness. Their relative usage, however, changes over time and varies across societies. This paper attempts to explain this phenomenon by endogenizing agent trustworthiness as a response to potential returns. When monitoring becomes relatively cheaper and more widely used over time, agents acquire lower trustworthiness and hence trust declines, which may actually drive up the overall governance cost in society. An innovative finding is the inherent conflict of interests between principals and agents in using trust and monitoring: higher trustworthiness benefits agents but not necessarily the principals, while cheaper monitoring makes agents worse off but benefits principals. So across societies, those giving agents/employees lower weights in choosing governance methods tend to have higher monitoring intensities and lower trust. These results are consistent with available empirical evidence.


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European Economic Association 2005 Meetings

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