A Three-Tier Agency Model with Collusive Auditing:

We construct a simple three-tier agency model, which is an extension of the familiar screening (self selection) models and can be placed in line with the collusion literature à la Tirole (1986, 1992), including Kofman and Lawarree (1993)’s auditing application. The basic trade-off consists of the discrete reduction in information rent vs. the improvement of margin-al incentives (outputs), and thus we have “Efficiency at the top ” and “Downward distortion at the bottom ” at the optimum. Then, we theoretically compare the “collusion-proof ” regime and the “no-commitment/renegotiation ” regime. We extensively utilize a graphical explanation, which provides us with clear intuition and logic of the optimal solutions and their comparative statics, as well as robust implications for corporate governance reform. Last, as an extension, we show that when the private information of the two agents is perfectly correlated, the princi-pal can implement the full information first best optimum at no incentive cost