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As mentioned earlier, one way of manipulatingthe informationis to ignore it. This is the case when minor "thefts"and perquisites are not reported. Such private benefits include the use of material and services for personal ends (tools, clerical supplies, long-distance phone calls, use of the firm'semployees to redecorate a home, and so forth), days off, plush offices, expense accounting.7 Sometimes information may be hard to dispose of; it may then be useful not to obtain it: "Inside [the firm] nominal surprise was also a preventive of conflict. For example, safety and health inspectors usually telephoned in advance of visits so that they would not see unsafe practices or conditions they would feel obliged to report" (Dalton, 1959: 48).

Another way to manipulate the information is to distort it. The effect of collusion on auditing is now well documented.8 Examples of ingenious distortions of records abound, from the creation of fictitious personnel on payroll to changes of job titles, reports of nonexistent pieces, and so forth. Note also that accounting distortions are not the only type of auditing distortions; for example, quality tests can be manipulated.9 Manipulationof informationis also very common when a shop or a group of employees decides not to implement changes it did not originate. For instance, the supervisor does not enforce the officialprocedures and the subordinates act cooperatively: the subordinates "keep key persons among interlocking departments informed of change in unofficial methods, and, at the proper time, they teach new members the distinctions between their practices and official misleading instructions"(Dalton p. 56; emphasis in text). It is also common not to apply safety rules. Accidents are then kept off the record. 10 I would like to stress the importance of reciprocity in these examples. This aspect is emphasized in the contributions quoted above, and it is more generally developed in Gouldner (1961), who insists on the universality of the norm of reciprocity. Thus, one-sided favors call for reciprocated ones. For instance, a foreman manipulates the information relevant to the appraisalof his workers' performance. In return, workers can do a number of favors for their foreman. These can include refraining from activities such as unrest, going on strike, leapfrogging for complaints. Also, when facing difficulties, employees place the responsibility not on their supervisors, but on higher

7. See Dalton, chap. 7.

8. See, e.g., Dalton (1959: 32), Williamson (1975: 146), and Antle (1984). In other contexts, see also Williamson (1967a) and Schmalensee.

9. Dalton (1959: 85-86) has observed that chemists manipulate the sample experiments to "prove"that the standardsof quality are met. In this example, line foremen in return "notifythe chemists, rather than their superior, of anything 'going wrong' that would reflect on them, and cooperate to reduce the number of analyses the chemists have to make."

10. See Dalton (pp. 80-85) for a discussion of how and why workers may cooperate in such a deception.

This content downloaded from on Mon, 28 Oct 2013 01:51:38 AM All use subject to JSTOR Terms and Conditions 186 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 levels of the hierarchy (Crozier, 1963: 52). Other nonmonetary transfers include mutual affection and respect, as emphasized by the Human Relations School (for example, see Etzioni, 1964: 34). The foreman, by defending his workers, obtains a better climate within his shop and he is thus more likely to avoid trouble (Crozier, p. 56).

Covert transfers are diverse in nature. First, many of the transfers described earlier are linked to the manipulationby one party of the information possessed about another party (forexample, the supervisor conceals information that is detrimental to the agent, and conversely). Some transfers come from direct actions that benefit the other party.1 A widespread enforcement mechanism for the coalition under such transfershas to do with the repetition of the relationship between the colluding parties. I will emphasize this aspect in part 4.

Second, there is another type of transfer, one which is somewhat out of the (current)realm of economics but which is very importantin practice. It has to do with face-to-face relationships, and includes mutual affection and respect.

It applies even to relationships that are not repeated. 12 It is just very unpleasant to hurt someone one is facing.

The model developed in part 3 chooses to formalize yet another type of covert transfer:monetary ones. Although such transfers do exist-monetary bribes in contracting; private discounts in business (for example, frequent flyer bonuses received by executives rather than by their firms);l3 auditors obtaining management advisory service contracts from or (now illegally) holding shares of their clients-they are usually fairlylimited. The reason why this is so is easily understood. A monetary transfermay be observed by parties that do not belong to the coalition and may be used as evidence of its existence. Nonmonetary transfersare not as conspicuous; or at least, they are harder to use as evidence of a coalition.14 Thus, most covert transfers are nonmonetary. The purpose of positing monetary transfers in the theoretical model of part 3 is expositional convenience. This will enable me to make a number of my points using standard economic analysis. I do believe, however, that considering only monetary transfers is restrictive. Although my results are strongly suggestive of what

11. Note that, at a formal level, the two types of transfersare very similar. The delegation of actions to parties mainly stems from informational problems. This lack of distinction is well illustrated by a promotion example: what is the difference between the supervisor's concealing information detrimental to the agent and his promoting the agent directly?

12. Think of the very strict rules that can be imposed on employees checking on people they will never see again (e.g., conductors on trains).

13. Note that firms could force their employees to return their bonuses. Thus, the outcome may well be interpreted as a coalition against the taxpayer.

14. Note that in some cases the covert transferscan actually be observed by the principalbut the latter can hardly use this observation, as there is some probabilitythat the transferis justified.

In other words, the principal is unable to show that the transfer is the outcome of a coalition against him. For example, the defense contractorcan always argue that he hires the civil servant because of the latter's great talent.

–  –  –

occurs under nonmonetary transfers, the latter should originate new features.15 Observed collusive behaviors are only the tip of the iceberg. Anticipating that their members have incentives to collude, organizationscan and do set up incentive schemes that restrict the formationand thus the effect of coalitions.

In some cases, in equilibrium, no coalition forms that can be observed by outsiders (see the equivalence principle in part 3). However, coalitions are latent and do influence organizationalbehavior. Thus, the mere observation of collusive behavior understates the influence of coalitions on an organization.

Later I shall emphasize the restrictions on communication in organizations. Nonverifiable reports will hardly be requested. Even verifiable reports will have a somewhat limited effect on rewards (see part 3). This limited communication, which is consistent with both detailed and casual evidence, is a piece of the submerged part of the iceberg.16 I will analyze other pieces in part 4.


3.1. THE MODEL Consider the following simple principal/supervisor/agenthierarchy.

The parties. The agent is the productive unit. The profit x created by the agent's activity depends on a productivity parameter 0 and on the effort e 0

he exerts:

–  –  –

The agent's disutility of effort is equal, in monetary terms, to g(e), where g is increasing, strictly convex, and g(O)= g'(O) = 0. The principalreceives profit x, and gives wage W to the agent. The latter has an increasing, differentiable, and strictly concave Von Neumann-Morgenstern utility function U. We will assume that there exists w such that

lim U(W) = -o. W -- w

15. For instance, they may not add up to zero within a coalition; some may be inefficient, even from the point of view of the coalition (sexual harassment);others may be desirable, even from a social point of view (acts of cooperation).

16. As Katz and Kahn observe: "The typical upward communication loop is small and terminates with the immediate supervisor. He or she may transmit some of the informationto the next higher level, but generally in a modified form."

This content downloaded from on Mon, 28 Oct 2013 01:51:38 AM All use subject to JSTOR Terms and Conditions 188 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 The agent's expected utility is EU[W - g(e)] (the uncertainty will be described later).

There exists an ex- ante competitive supply of agents, with reservation wage Wo, and reservation utility U U(Wo).The agent's participation(individual rationality)constraint is

EU[W - g(e)] U.

The supervisor's role will be described along with the uncertainty and the informational assumptions. For the moment, let us just assume that the supervisor exerts no effort, receives a wage S from the principal, and has an increasing, differentiable, and strictly concave Von Neumann-Morgenstern utility function V. The supervisor's expected utility is EV(S).

There exists ex- ante a competitive supply of supervisors, with reservation wage So, and reservation utility V V(So). The supervisor's participation (individual rationality) constraint is

EV(S) V.

In the discussion below, I will assume that So = 0. This assumption corresponds to the case in which the principal must hire a supervisor for other purposes than supervision (organization,advising, coordination, and so forth).

The opportunity cost of the supervisory function is then zero because of the supervisor'sdual role. More generally, one can admit So 0. The decision of whether to hire a supervisor is then endogenous. The results obtained below remain valid on the condition that a supervisor is hired.

Finally, the principal is the owner of the technology used by the agent (or else is the buyer of the good produced by the agent). He designs the main contract and offers it to the supervisor and the agent. He is risk-neutral. His expected utility is E(x - S - W). (I assume that the principal is risk-neutral so that the supervisor plays no role in insuring the principal.) Uncertainty and Information. The productivity parameter can take two values: Q and 0, such that 0 a 0. Q and 0 will later be called the bad (low) and good (high) states of productivity. Let AO -- - Q.

There are four states of nature, indexed by i. State of nature i has proba

–  –  –

For a given 0, the supervisor's signal s can thus take two values: {0, 0), where 0 denotes observation "nothing."

The agent's information structure is finer than the supervisor's, which is finer than the principal's. For simplicity, I assume the agent knows whether the supervisor learns the true state of productivity; that is, the agent knows the state of nature.

Lastly, I assume the agent's effort e is not observable by the other two parties.

Timing. The principal first offers a contract. For the moment I do not distinguish between the main contract and side contracts. The latter will be introduced shortly. The contract specifies the transfers S and W to the supervisor and the agent, as functions of the commonly observed variables.

These observables are the profit x and the supervisor's report r to the principal.

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