Authority and disclosure in managerial agency problems

The information asymmetry between managers and investors is so potentially large that, unlike in the standard principal-agent model, investors may be unable to determine a firm's performance with certainty. To verify the reports issued by managers, investors rely on regulatory oversight and third-party monitors, such as auditors. The structure of a manager's compensation, the intensity of monitoring, and the severity of the penalties imposed by regulators jointly determine a manager's behavior. Little is understood about the nature of the resulting system of incentives, which is the first problem I address in this dissertation.; I show that a manager may respond to an increase in incentive compensation by decreasing productive effort, despite the presence of an auditor. A policy that raises the penalty imposed on the manager for misreporting earnings improves the manager's incentives, but may worsen the auditor's incentives. If the auditor's oversight becomes sufficiently lax, such a policy may decrease investor welfare. When the manager and auditor side contract, the auditor is more likely to misreport profits, but gains better access to the manager's information about profits; the net impact on the quality of the auditor's reporting is therefore ambiguous. The model predicts that raising the liability of auditors is the most robust instrument for improving investor welfare.; Given the difficulty of measuring performance, incentive compensation may be a particularly costly instrument for aligning the interests of managers and investors. Another approach to limiting opportunism is to restrict managerial authority. To address this second issue, I explicitly model the costs and benefits of increasing managerial discretion. The optimal degree of authority depends on the value of a manager's information and knowledge and the cost of the incentives necessary to ensure that the manager does not abuse his power. Career concerns generally lower the cost of incentives, but may cause managers to ignore valuable information and take conservative courses of action, undermining the reason for delegating control in the first place. Investors can eliminate this conservative bias by using long-term contracts, which reward successful managers with greater future compensation and authority than would otherwise be optimal.