Vendor-induced Performance Monitoring, Signaling, and Incentive Contracts in IT Outsourcing

Performance monitoring is often used by the principal to lower the rent paid to the agent due to moral hazard. However, in global sourcing of IT services, we observe a phenomenon wherein vendors voluntarily provide costly monitoring systems which allow the client to obtain accurate and timely information on their own performance. It is puzzling as why do vendors themselves offer mechanisms that lower their own rent extraction opportunities? We develop a model of IT outsourcing wherein IT services quality is non-verifiable, vendors have private information about their capabilities and quality-improving effort is unobserved by the client. Given the strategic and long-term nature of IT services contract, identifying the high capability vendor and inducing him to exert optimal level of quality-improving effort is critically important for the client. We show that performance monitoring is used as a credible truth-revealing signaling device by vendors to obtain favorable contracts. By committing to costly performance monitoring and convening verifiable signals on his private information to the client, a high capability vendor is able to separate his expected payoff from that of the free-riding low capability vendor. The dynamics of truth-revealing signaling with performance monitoring involves that the client credibly commits to a long-term relationship with the appropriate vendor with incentive contracts contingent on the verifiable signals from performance monitoring. When the monitoring-effort-output space can be partitioned, client achieves efficient screening. Otherwise, in order to achieve separation and optimize on information rent to the high type vendors, the client sacrifices allocative efficiency and efficient effort is not induced.