To Trust or to Monitor: A Dynamic Analysis

In a principal–agent framework, principals can mitigate moral hazard problems not only through extrinsic incentives such as monitoring, but also through agents’ intrinsic trustworthiness. Their relative usage, however, changes over time and varies across societies. This paper attempts to explain this phenomenon by endogenizing agent trustworthiness as a response to potential returns. It …nds that agents acquire lower trustworthiness when monitoring becomes relatively cheaper over time, which may actually drive up the overall governance cost in society. Across societies, those giving employees lower weights in choosing governance methods tend to have higher monitoring intensities and lower trust. Keywords Monitoring Trustworthiness Trust Screening Economic Governance JEL Classi…cation Numbers D2 J5 L2 M5 Z13.