Monitoring Subcontracting in a Supplier's Hierarchy

Consider the following contractual hierarchy: a principal who contracts with a contractor below her who then contracts with a subcontractor. The principal requires goods made from both firms in equal proportions. The question we study is whether, at zero cost, the principal would wish to monitor the contract between the subcontractor and contractor. Without monitoring the contractor will determine the type of the subcontractor. Hence, when contracting with the principal he can extract an information rent on this knowledge. Monitoring would reveal the subcontractor type and so lower the principal’s bill. However, if the principal monitors the contract between contractor and subcontractor then he may prefer to not screen the subcontractor. So, the contractor must be offered an incentive to screen below. The paper shows that the second of these costs is smaller for a range of parameter values, so that monitoring and incentivizing screening is cheaper than not monitoring.