Mechanism design with collusive supervision

We analyze an adverse selection environment with third party supervision. We assume that the supervisor and the agent can collude while interacting with the principal. As long as the supervisor is symmetrically informed with the agent, the former’s existence does not improve the principal’s rent extraction. This is due to the coalitional efficiency between the supervisor and the agent. However, asymmetric information between these two parties can cause a collusion failure, which undermines the coalitional efficiency. In that case, we show that the principal can increase his payoff, by manipulating the agent’s opportunity cost for colluding with the supervisor. Delegating the authority to contract with the agent to the supervisor is not successful in enhancing the principal’s payoff, since the principal loses the instrument to manipulate the opportunity cost of collusion under this organizational form. The increase in the principal’s rent extraction does not necessarily imply an overall welfare improvement. Social welfare may decline with the introduction of the supervisor.