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Mechanism Design with Collusive Auditing : A Three-Tier Agency Model with "Monotone Comparative Statics" and an Implication for Corporate Governance

We build a theoretical model to examine how supervision (auditing) can be utilized to enhance the efficiency of corporate governance and how collusive supervision (auditing) can be deterred. We introduce the outcomes of “Monotone Comparative Statics” ala Topkis (1978) and Edlin and Shannon (1998), and Milgrom and Segal (2002)’s generalized envelope theorem, and construct a three-tier agency model with a mathematically tractable structure. This should be an advantage in modeling in comparison with the collusion literature e.g., Kofman and Lawarree (1993)’s auditing application of the three-tier agency model ala Tirole (1986, 1992). The basic trade-off involved in adding the auditor (supervisor) into the hierarchy is the benefit from the discrete reduction in information rent and the improvement of marginal incentives (outputs) versus the resource cost of the auditor (supervisor), and this bottom line is consistently preserved through the extension and generalization of the model. In addition to the theoretical (mainly technical) investigation, the paper also derives some clear and robust implication applicable to corporate governance reform.