Does Incentive Pay Substitute for Monitoring? The Role of Managerial Skills and Span of Control

We model the conditions under which firm agency issues are tackled through incentive pay as opposed to monitoring. The model shows that a larger span of control makes labor surveillance less effective as an effort extraction mechanism, whereas managerial skills increase the opportunity cost of monitoring. As a result, the use of pay-for-performance schemes is more likely in firms with a lower staff-to-managers ratio and more skilled managers. An empirical analysis on firm-level Italian data produces results coherent with our theoretical predictions. Taken together, our results help to explain the highly heterogeneous use of incentive contracts among firms.