Equilibrium Extortion, Bargaining Power, and the Tradeoff between Informational and Corruption Rents

The paper considers a principal-supervisor-agent hierarchy where the supervisor is self-interested and able to manipulate information. The supervisor’s self interest may motivate him to accept a bribe in exchange for a report that is overly favorable to the agent or to extort the agent by demanding payment for a favorable report to which the agent is fairly entitled. When attempting to extort the agent, the supervisor may become irrationally attached to his bargaining position, including threats that if carried out would incur a loss ex post; realizing this, the agent may accede to extortion. In spite of this possibility for strictly positive extortion payments, incentives are improved – in that the information rent is lowered – by reducing the bargaining power of the agent, relative to that of the supervisor. However, the expected cost of these payments – the corruption rent collected by the supervisor – is passed on to the principal through the agent’s participation constraint, and this rent is lowered by increasing the agent’s relative bargaining power. Thus there is a tradeoff between informational and corruption rents: Increasing the agent’s relative bargaining power increases the information rent and decreases the corruption rent, and the overall effect on the value of the optimal contract tends to follow a simple rule: Strong supervisors are preferred when supervision is less effective, and strong agents are preferred when supervision is more effective.