Working Paper, Brown University, Department of Economics 2005-08
This paper argues that an external monitor can be less effective when there is uncertainty regarding the quality of the management and the business environment. In a two-period model, an outside monitor, who initially does not know managerial quality, can have the manager fired. The manager makes investment decisions based on noisy but informative private information, and if she is the empire-building type, derives private benefits from over-investment. Uncertainty imposes extra costs on the monitor, and leads to equilibrium in which the riskneutral monitor gives up monitoring ex ante. The model highlights the limits of external monitoring, and suggests that outside monitoring cannot fully substitute for internal monitoring by the board. Some implications of this model are confirmed in empirical tests.