This paper analyzes the trade-off between monitoring and incentives in a pr
incipal-agent relationship with moral hazard. We derive general results on
the optimal monitoring - incentives mix for the case where both parties are
risk-neutral and the agent faces a limited liability constraint. We show t
hat the principal uses less monitoring and stronger incentives if the agent
's liability limit is relaxed or if monitoring costs increase. To induce mo
re effort on the part of the agent, the principal resorts to more monitorin
g or to stronger incentives, or both. In particular, there are cases where
the cheapest way to induce more effort is to use lower-powered money incent
ives, but with much more precise monitoring. (C) 2001 Elsevier Science B.V.
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