Incentives versus monitoring within the firm: Understanding Codes of Corporate Governance

Abstract

The paper analyzes the interaction between two different internal mechanisms of the firm: a performance-based scheme and a monitoring device. We show that it is always optimal to use both instruments if available; the two instruments are complementary instruments. We also find that ownership structure becomes relevant in determining the optimal contract. Using these findings, we study the incentives to adopt a Code of Corporate Governance. The Code can be understood as an exogenous monitoring technology. We find that some firms may optimally choose not to adopt the Code because they are providing better incentives. Others may adopt it but not always use it to reach more efficient outcomes.