Reputations, Investigations and Self Regulation

Consider a principal who hires an agent, e.g., a broker is hired to fill stock orders. The outcome may be good or bad, e.g., the orders may be filled at favorable or unfavorable prices. A bad outcome may simply reflect bad luck or it may result from the agent defrauding the principal. How is the agent’s incentive to defraud the principal restrained? With a dynamic costly-state verification model we examine two possibilities: (i) reputational penalties, meaning that principals can choose not to transact with an agent who has a bad history even if there is no evidence of fraud; and (ii) investigations, meaning that at a cost, an agent’s performance can be directly checked for fraud. Reputational penalties have no direct cost but they are imprecise in the sense that an agent can be penalized even if it was just bad luck. Investigations are costly but precise in the sense that an agent is penalized only if he is found to have committed fraud. We examine how principals would balance the two ways of controlling an agent’s incentives. Then we examine the incentives of agents to form a self-regulatory organization to conduct its own investigations of agent performance and to penalize agents who are caught cheating. We show that the threat of SRO investigations can enhance agents’ welfare but reduce the welfare of principals. In effect, SRO investigations can inefficiently – from the principal’s perspective – crowd out reputational penalties.