25620054

Opportunism in Organizations
Author(s): Kouroche Vafa

Source: Journal of Law, Economics, & Organization, Vol. 26, No. 1 (Apr., 2010), pp. 158-181
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/25620054
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158 JLEO, V26 N1
Opportunism in Organizations
Kouroche Vafal*
Universite Paris Descartes and Universite Paris 1 Pantheon-Sorbonne, CES
This article characterizes the incentive contracts that optimally immunize an or
ganization against the opportunistic activities of its members. We analyze an

agency relationship with moral hazard where a principal relies on a supervisor
to obtain verifiable information about an agent's output. The supervisor's discre
tion allows him to engage in two types of individual opportunism, namely abuse
of power and abuse of authority, as well as two types of group opportunism,
namely collusion with the agent and collusion with the principal. Individual
opportunism occurs when the supervisor asks a tribute to reveal information,
whereas group opportunism occurs when the supervisor receives a bribe to

conceal information. We find that the effective, and hence most noxious, form
of opportunism is individual opportunism and derive the opportunism-proof

contracts, that is, the optimal contracts that protect the organization against both
individual and group opportunism.
"The essence of an organization is limitation of the autonomy of all its
members or parts, since all are subject to power from the others ..."
(Hickson et al. 1971: 217).
"Corruption in general is harmful to economic, political, and organiza
tional development. But all forms of corruption are not created equal.
Some forms are more harmful than others" (Klitgaard 1988: 46).
1. Introduction
A question that is central to most modern organization theories is this:
How should an organization be designed to cope with the opportunistic activ
ities of its members?1,2 Recently, this question has been investigated within
*Departement GEA and LIRAES, Universite Paris Descartes, IUT de Paris. Email: kouroche
.vafai@libertysuif.fr.
I am grateful to the coeditor, Tracy Lewis, and an anonymous referee for helpful comments.
1. Older such theories include managerial, sociological, and political theories of the firm (e.g.,
Marris 1963; Mintzberg 1983, 1985). More recent such theories include transaction cost, agency,
and corporate governance theories.
2. The idea of an organization designed to prevent the misuse of power and authority dates back
to at least before the First World War. This idea is, for example, central in Max Weber's theory of
bureaucracy.
The Journal of Law, Economics, & Organization, Vol. 26, No. 1,
doi:10.1093/jleo/ewn025
Advance Access publication January 16, 2009
? The Author 2009. Published by Oxford University Press on behalf of Yale University.
All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org
Opportunism in Organizations 159
principal?supervisor?agent hierarchies. However, although these hierarchies

are vulnerable to several types of opportunistic activity, the literature to date
has essentially focused on the deterrence of one of them, namely collusion
between the supervisor and the agent.3'4 Our article departs from this literature
by characterizing the optimal incentive contracts that immunize principal

supervisor?agent organizations against the various opportunistic activities
to which they are vulnerable. The article therefore extends Tirole's (1986,
1992) concept of collusion-proofness to the more general concept of

opportunism-proofness. In so doing, the article presents a theory of merito
cratic organizations, that is, organizations with a reward structure based

exclusively on professional achievement.
For our analysis, we consider a principal-supervisor-agent organization
with moral hazard in which hard information/evidence about the output pro
duced by the agent is obtained through supervision. The role of the supervisor
is thus to produce a verifiable report on the agent's output. Since the super
vision technology is imperfect, the supervisor obtains hard information only
with a certain probability. The informed supervisor then has the discretion to
conceal information and pretend that supervision has revealed no hard evi
dence.5 This allows him to engage in four types of opportunistic activity.
More specifically, when supervision reveals evidence that the agent has pro
duced a low output, the supervisor has three options. He may choose not to
engage in opportunistic activities and directly make a truthful report, decide to
form a coalition with the agent and accept a bribe in return for concealing
evidence (since then the agent will receive a higher wage), and, finally, choose
to approach the principal for a tribute not to conceal evidence (so that the prin
cipal will pay the agent a lower wage). This last option thus consists in not
directly making a truthful report but asking the principal a tribute for doing
so. The two types of opportunistic activity are, respectively, referred to as
supervisor?agent collusion and abuse of power and the bribe or the tribute
obtained by the supervisor is their respective stake. When engaging in oppor
tunism, the supervisor therefore expects to capture a rent whose size depends
on the difference between the payments?for the other involved party?

associated with a truthful report and an uninformative one, discounted by
a deadweight loss connected to (unofficial) side transfers. Since when engag
ing in abuse of power the supervisor may obtain an additional payoff, under the
form of a tribute, for truthful reporting, we find that he will prefer to abuse his
3. Tirole (1992) and Laffont and Rochet (1997) provide extensive surveys of the literature on
collusion.
4. In the managerial and sociological literatures on organizations, opportunistic activities are
often referred to as political activities or politics. Mintzberg (1983: 172) defines politics in the
following way: "Distilled to its essence, therefore, politics refers to individual or group behavior
that is informal, ostensibly parochial, typically divisive and, above all, in the technical sense,
illegitimate?sanctioned neither by formal authority, accepted ideology, nor certified expertise
(though it may exploit any one of those)" (emphasis removed).
5. Because it is hard evidence, the supervisor's information can only be concealed but not
forged.
160 The Journal of Law, Economics, & Organization, V26 N1
power than to directly make a truthful report as long as this tribute is positive
and irrespective of the level of inefficiency in transferring it. We next find that
it is in the supervisor's interest to engage in abuse of power rather than in
collusion with the agent. To optimally prevent the supervisor from engaging
in abuse of power and asking a tribute, the principal must then make identical
the payments associated with a truthful report and an uninformative one so that
there is no stake anymore for the supervisor in approaching the principal. This
in turn systematically crushes the stake of forming a coalition with the agent.
Preventing the possibility of abuse of power thus also prevents the possibility
of supervisor-agent collusion. We show that the reverse is not always true.
Similarly, when supervision reveals evidence that the agent has produced
a high output, the supervisor has three options. He may decide not to engage in
opportunistic activities and directly make a truthful report, choose to form a co
alition with the principal and accept a bribe in return for concealing evidence
(since then the principal will pay the agent a lower wage), and, finally, decide
to ask the agent a tribute not to conceal evidence (so that the agent will receive
a higher wage). As above, this last option consists in not directly making
a truthful report but asking the agent a tribute for doing so. The two types
of opportunistic activity are, respectively, referred to as principal?supervisor
collusion and abuse of authority. We find that the supervisor prefers to engage
in abuse of authority rather than in collusion with the principal. Following the
same reasoning as in the case where supervision reveals evidence that the agent
has produced a low output, to optimally prevent the supervisor from asking the
agent a tribute to report truthfully, the principal must make identical the pay
ments to the agent associated with a truthful report and an uninformative one.
This in turn systematically crushes the stake of forming a coalition with the
principal. Preventing the possibility of abuse of authority therefore also pre
vents the possibility of principal?supervisor collusion, whereas the reverse is
not always true.

Referring to abuse of power and abuse of authority as individual opportunism?
since when engaging in these types of opportunism the supervisor acts alone?and
to supervisor?agent collusion and principal-supervisor collusion as group oppor

tunism, our main findings are therefore that the supervisor optimally chooses to
engage in individual opportunism rather than in group opportunism and that

incentive contracts that optimally prevent individual opportunism also prevent
group opportunism, whereas the reverse is not always true.6 Differently stated,
the effective form of opportunism is individual opportunism. This result stands
in sharp contrast to what is implicitly posited in the existing literature. Indeed,
by focusing on the design of supervisor?agent collusion-proof contracts, the incen
tive contracts literature implicitly suggests that group opportunism, in the form
6. The possibility of individual and group opportunism has long been recognized by sociolog
ical studies of organizations. For example, Mayes and Allen (1977: 676) write, "In formulating
political objectives, an individual within an organization should first take stock of whether desired
outcomes are sanctioned by the organization. The political actor would determine if these out
comes are attainable through solitary action or if other persons must be involved."
of supervisor?agent collusion, is generally the effective type of opportunism in

organizations. Our results show that ignoring individual opportunism may lead
the principal to offer inefficient contracts. Individual opportunism therefore chal
lenges the received theory of incentive contracts.
As suggested by an increasing number of empirical studies and news

reports, opportunism in organizations is a widespread, harmful, and costly phe
nomenon. For example, Crozier (1967) and Edwards (1979), among many
others, provide evidence on the frequent occurrence and noxious consequences
of collusive activities and abuse of power. Concerning abuse of power, Crozier
(1967: 160), in his famous study of a French tobacco plant, writes, "Subordi
nates try to increase their amount of discretion and utilize it to oblige higher
ups to pay more for their co-operation." Abuse of authority has also been
investigated by an abundant empirical literature. One particular form of abuse
of authority that has been extensively analyzed is sexual harassment.7 An in
vestigation conducted by the United States Merit Systems Protection Board in
1989 have revealed that 42% of women and 15% of men report that they have
been sexually harassed on the job (Flynn 1991). Timmerman and Bajema
(1999) have obtained comparable results in their study of sexual harassment
in Northwest European countries.
Although opportunistic activities may be of many types, three-level agency
models have rarely considered other types of opportunism beside supervisor
agent collusion and have not accounted for the simultaneous presence of all
possible harmful opportunistic activities that may occur in these models.8

There is, however, a small emerging literature that investigates optimal con
tracting in the presence of two types of harmful opportunistic activity, namely
"supervisor?agent" collusion and extortion. For example, Marjit et al. (2000)
study these two specific opportunistic activities in the context, very different
from ours, of tax evasion. Unlike in this article where opportunism involves
members of the same organization in a hard information context, their article is
concerned with collusion and extortion involving an insider (a tax inspector)
and an outsider (a taxpayer) in a soft information environment. In recent

articles, Vafai' (2002, 2004a, 2005) introduces the possibility of abuse of
authority inside three-level hierarchies. He characterizes the optimal incentive
contracts in different such hierarchies exposed to both supervisor?agent col
lusion and abuse of authority. Unlike us, he does not account for abuse of
power and principal?supervisor collusion. By contrast, we consider most of
the opportunistic activities depicted in the sociological and empirical literature
and prove that there exists a contractual way to protect organizations against
these activities.
7. See also Edwards (1979) for evidence on other forms of abuse of authority in organizations.
8. Other types of opportunism than collusion have been investigated by economists. For ex
ample, Milgrom (1988), Shleifer and Vishny (1989), and Crocker and Slemrod (2007) consider,
respectively, influence activities, managerial entrenchment, and earnings manipulation in firms.
Unlike these authors, we are concerned with opportunistic activities occurring in a principal
supervisor-agent organization with hard information in the tradition of Tirole (1986, 1992).
The plan of the article is as follows. The principal-supervisor?agent orga

nization model is presented in Section 2. Section 3 characterizes the optimal
incentive contracts in the absence of opportunism. Section 4 describes the four
types of opportunistic activity that may occur in principal-supervisor?agent
organizations. Section 5 identifies the effective types of opportunism in these
hierarchies and characterizes the opportunism-proof contracts. Section 6 con
cludes the article.
2. The Model
We consider a risk-neutral principal?supervisor?agent organization under
moral hazard with the following characteristics.
2.1 Production Technology

The agent (she), who is in charge of the production task, has the choice
between two effort levels, e G {0, 1}; that is, she may either shirk (e = 0)
or work (e = 1). Neither the principal nor the supervisor can observe the
agent's effort level. The production technology is such that if the agent decides
to work, she produces a high output xH > 0 with probability n ? (0,1] and a low
output xL = 0 with probability 1 ? n. If instead the agent decides to shirk, she
produces jcl.
2.2 Supervision Technology

Hard information or, equivalently, hard evidence about the output produced by
the agent can only be obtained through supervision. The principal (it) and the
agent are unable?due, for example, to a lack of time or expertise?to perform
the supervisory task. The role of the supervisor (he) is then to produce a verifi
able report on the agent's output. The hard evidence obtained by the supervisor
is verifiable exclusively by the persons to whom he shows it. This evidence is
publicly verifiable only when the supervisor produces his report.

We assume for simplicity that supervision is costless. Given that the super
vision technology is imperfect, the supervisor obtains hard evidence about out
put only with probability p e (0, 1). Consequently, the supervisor's report, r,
belongs to / = {xL, 0, jch}, where r = 0 indicates that no evidence has been

obtained. Since the information/evidence obtained by the supervisor is hard, it
can be concealed but not forged. That is, when the supervisor obtains hard
evidence that the agent has produced xL (respectively jch), he may report
r = 0 but not r = xH (respectively r ? jcl).
2.3 Payoffs
The agent's and the supervisor's utility functions are, respectively, UA(w9 e) =
w ? ye and lP(s) = s, where w and s are the transfers received from the prin
cipal and y > 0 is the agent's disutility of effort. Without loss of generality, the
agent's and the supervisor's reservation utilities are normalized to zero. We

assume that xH is large enough for it to be in the principal's interest to engage in
production. The principal must therefore elicit the production effort level e = 1
for its organization to be valuable. The principal's utility function is then

lf(w, s) = 7DcH - C(w, s), where C(w, s) is the expected cost of production
and supervision or, equivalently, the expected cost of the organization.
2.4 Contracts
Given that hard information about the output is exclusively obtained through
supervision, contracts depend on the supervisor's report. The principal offers
a contract (wL, w0, wH) to the agent, where wL and wH are the wages she
receives when r ? xL and r ? xH, respectively, and w0 is the wage she receives
when r = 0. Similarly, the principal offers a contract (sL, sn) to the

supervisor. Finally, we assume that the agent's and the supervisor's wages
must be nonnegative due to their limited liability.
2.5 Opportunism
Before turning to the description of the various opportunistic activities to
which the principal?supervisor?agent organization is vulnerable, let us briefly
expose the terminology that will be used throughout the article. In accordance
with the sociological literature on organizations, we use authority to describe
a superior control over his subordinate and power to describe ascendancy

employees have over their superiors. As expressed by Breton (1995: 418),
"If we use the word authority to describe the jurisdiction, dominion and control
that principals possess over agents, we can use the word power?as sociolo
gists often do (see, among many, Crozier (1967), Pfeffer (1981), Mintzberg
(1983))?to depict the ascendancy, mastery or sway that agents have over prin
cipals and other agents." The supervisor has therefore power over the principal
and authority over the agent.
As almost all models of collusion, we consider ex post opportunism, that is,

opportunism occurring after the supervisor has obtained information/evidence
on output. Since the supervision technology is imperfect and the information
obtained by the supervisor cannot be forged, the supervisor has discretion to
conceal information in his report. The supervisor's discretion opens the door to
opportunistic activities. We assume that, when engaging in opportunism, the
supervisor unofficially shows (but does not give) the hard evidence he has
obtained to the other involved party. That is, in line with most of the existing
literature on collusion, opportunism takes place under symmetric information
on evidence among involved parties. We depart from the existing literature by
allowing the supervisor to engage in all possible opportunistic activities to

which principal-supervisor?agent organizations with hard information are
vulnerable. The supervisor's discretionary power allows him to engage in
two types of individual opportunism, namely abuse of power and abuse of
authority, as well as two types of group opportunism, namely collusion with

the agent and collusion with the principal.
More precisely, when supervision reveals evidence that a low output has
been produced, the supervisor has three options. The first option is not to en
gage in opportunistic activities and truthfully report r ? xL. The second option
is to take a bribe from the agent to conceal information (since then the agent
will receive a higher wage). In this case, the supervisor colludes with the agent
and, in exchange for a bribe, makes an uninformative report r = 0 instead of
a truthful report r ? xL. The principal then pays w0 to the agent and the agent
pays the promised bribe to the supervisor. The third option is to ask the prin
cipal a tribute not to conceal information (so that the principal will pay the
agent a lower wage). In other words, this option consists in not directly making
a truthful report but asking the principal a tribute for doing so. When choosing
this option, the supervisor abuses his power by threatening the principal with
an uninformative report r = 0 in case it refuses to comply and to pay him

a tribute for truthful reporting. Therefore, if the principal refuses to comply,
the supervisor reports r = 0. If instead the principal accepts to comply, the
supervisor reports r = xL and the principal then pays him the promised
tribute.9'10
When supervision reveals evidence that the agent has produced a high out
put, the supervisor also has three options. The first option is not to engage in
opportunism and truthfully report r ? jch. The second option is to collude with
the principal and, in exchange for a bribe, conceal the information he has
obtained (since then the principal will pay the agent a lower wage). In this
case, the supervisor reports r ? 0 instead of truthfully reporting r = xH
and the principal pays him the promised bribe. The last option is to ask the
agent a tribute not to conceal information (so that the agent will receive a higher
wage). Expressed differently, this option consists in not directly making a truth
ful report but asking the agent a tribute for doing so. When choosing this op
tion, the supervisor abuses his authority by threatening the agent with an
uninformative report r ? 0 in case she refuses to comply and to pay him a trib
ute. Therefore, if the agent refuses to comply, the supervisor reports r = 0. If
instead the agent accepts to comply, the supervisor reports r ? xu and the agent
then receives wH from the principal and, finally, pays the promised tribute to
the supervisor.
9. Notice that since?as in most real-world situations?the supervisor is essential to the agency
relationship, threatening him with firing and replacing him if he engages in abuse of power are
ineffective. Indeed, the issue of abuse of power will reappear with his successor.
10. Observe that the supervisor's commitments are not compatible. Indeed, if he colludes with
the agent he commits, in exchange for a bribe, to report r = 0, whereas if he abuses his power he
instead commits, in exchange for a tribute, to report r = xL. Thus, since the supervisor receives the
promised bribe or tribute only after having made his report and since the two possible types of
opportunism associated with the revelation of evidence that output is low are incompatible, he
cannot engage in both types of opportunism but only in one of them. Clearly, this argument is
also valid in the case where supervision reveals evidence that the agent has produced a high output.
Before proceeding with the analysis, note that there are thus two forms of
opportunism, namely individual and group opportunism, each composed of
two types of opportunism.
Concerning opportunistic activities, we make the following assumptions.
2.5.1 Observability. Opportunism is only observable to the involved parties.
2.5.2 Side Transfer Technology. In accordance with the literature on collu

sion, we assume that the technology used to transfer bribes and tributes, which
we refer to as the side transfer technology, is less efficient than the official
transfer technology (i.e., the transfer technology used by the principal to
pay its employees). This means that unofficial income can be transferred to
the supervisor at a rate k G [0, 1). The side transfer creates a deadweight loss,
that is, a side transfer of size t is only worth kt to the supervisor. There are
therefore transaction costs connected to side contracting. This may be, for ex
ample, because opportunistic activities are costly to organize. Transaction

costs of side contracting can also come from the nonmonetary nature of bribes
and tributes.11 Notice that if k ? 0, the side transfer technology is totally in

efficient, and hence opportunistic activities do not occur. The technology of the
organization is fully characterized by the vector (tt, p, k).
2.5.3 Unofficial Bargaining. Following Tirole (1992) and others, we assume

that the supervisor has all the bargaining power when engaging in opportunis
tic activities.
2.5.4 Unofficial Commitments. In concert with the existing literature on op
portunism in organizations, and more especially Tirole (1992) and Vafai'

(2002, 2005), we do not explicitly model the mechanism that ensures the cred
ibility of unofficial commitments (i.e., the supervisor's threat to report

r ? 0?in case of noncompliance of the other party?when choosing the op
tion to abuse his power or his authority as well as the principal's and the
agent's promises to pay a bribe or a tribute to the supervisor).12 Recent findings
in experimental economics and evidence derived from case studies of abuse of
authority in organizations show that reputational as well as various nonmon
etary mechanisms (e.g., emotions, reciprocity) sustain the credibility of com
mitments. We therefore take these findings and evidence as the starting point
of our modeling.
11. See Tirole (1992) for a discussion of different kinds of transaction costs.
12. In the standard model of collusion, the agent's promise to pay a bribe to the supervisor after
he has concealed information from the principal is not credible. Several exogenous mechanisms are
then invoked to ensure the credibility of this promise. On this issue, see, for example, Tirole (1992).
The discussions in Tirole (1992) and Vafai' (2002,2005) suggest that a single
type of mechanism is enough to guarantee the credibility of both unofficial
threats and unofficial promises. Moreover, there is no need to refer to alter
native mechanisms than those invoked in the literature on collusion to account
for both individual and group opportunism in three-level organizations. This
means that no additional assumption is needed to also investigate abuse of

power and abuse of authority in these organizations. There is thus no reason
to rule out the possibility of individual opportunism once the possibility of
group opportunism is taken into account.
2.6 Sequence of Events

The sequence of events is as follows: (1) The principal offers a contract (wL,
w0> wh) to the agent and a contract (s^, s0, sH) to the supervisor. (2) The agent
and the supervisor decide whether to accept or refuse the contract. If either
refuses, the game ends and they both get their reservation utility. If instead
contracts are accepted, the game continues as follows. (3) Supervision takes
place and the agent decides whether to work or to shirk. (4) Hard information
about the output produced by the agent is obtained with probability /?, and the
decisions of whether or not to engage in opportunistic activities are made. (5)
The supervisor produces a report. (6) Transfers take place, and (7) if oppor
tunism occurs, side transfers take place.
We look for a subgame perfect equilibrium of this game.
The principal's concern is thus to design contracts that both induce the effort
e ? 1 and cope with the four possible types of opportunism in order to min
imize the expected cost of production and supervision.
3. Opportunism-Free Organization
As a benchmark, let us first consider the case where k = 0, that is, the case
where none of the four possible opportunistic activities will occur. Since we
make the standard assumption that the agent chooses to work when indifferent,
her incentive compatibility constraint is p[nwn + (1 - n)wL] + (1 ? p)w0 ?

y > PWl + (1 ? P)w0 ?r> equivalently,
y
pn
wH - wL > ?. (1)
This equation makes the agent prefer to exert effort in equilibrium.

The agent's contract must also satisfy her participation constraint, p[nw
(1 - n)wL] + (1 - p)w0 ? y > 0. However, given that transfers must be
negative, the agent's participation constraint is always implied by her inc

tive compatibility constraint and will thus be ignored in the rest of the art
Since the agent and the supervisor are protected by limited liability, we
wL > 0, w0> 0, wH > 0, sL> 0, s0 > 0, sH> 0. (
Given that supervision is costless, the supervisor accepts any contract
(sl,S0,sh) G R+. That is, any contract (sl,S0,sh) E is individually
rational.
We make the standard assumption that the supervisor reports truthfully

when indifferent. In order to provide incentives to the supervisor to reveal
the information he has obtained, the principal must then also set 5L > s0
and sn > s0. Clearly, since it is systematically optimal to set s0 ? 0, and hence
the optimal contract offered to the supervisor in this case and in the subsequent
cases satisfies these two constraints, we will disregard them.
In the absence of opportunism, the program of the organization can thus be
written as
[Pno] rnin p[n(wH + sH) + (1 - n)(wL + sL)}
+(1 - p)(w0 + s0) s.t.(l) and (2).

The solution to this program is given in the following proposition.
Proposition 1. The opportunism-free contracts are (wL, w0, wH) = (0, 0,

y/(pn)) and (sL, s0, sH) = (0,0,0). Neither the agent nor the supervisor receives
a rent.
Proof. Since the expected cost of the organization is increasing in wages

paid and reducing wages does not make constraints more severe, the principal
sets the agent's and the supervisor's wages as low as allowed by the con
straints. In the absence of opportunism, the principal thus sets wL = 0, and
hence wn = y/(pn) from the agent's binding incentive compatibility constraint.
Similarly, the principal sets w0, s^, s0, and sH as l?w as allowed by the limited
liability constraints, that is, w0 = s^ = s0 = sH = 0. Q.E.D.

Proposition 1 states that, in an opportunism-free environment, the principal
does not need to provide rents to obtain information. This is not anymore true
when the supervisor engages in opportunistic activities. Indeed, as will be

shown below, when the organization is exposed to opportunism, optimal con
tracts are such that sL = y/(pn) > sH = s0 ? 0 and wH = w0 = y/(pn) > wL = 0.
The possibility of opportunism thus entails the payment of rents to both the
supervisor and the agent.
4. Opportunism
In this section and the subsequent one, we consider the case where k G (0, 1),
that is, the case where opportunism may occur.
4.1 Opportunism Related to the Realization of a Low Output

In the case where the supervisor obtains hard evidence that the agent has pro
duced a low output, he has the choice between engaging in one of two possible
types of opportunism and refraining from doing so. As discussed above, a prin
cipal?supervisor?agent organization with hard information is exposed to two
types of opportunism related to the realization of a low output, namely super
visor?agent collusion and abuse of power.
4.1.1 Supervisor-Agent Collusion. Collusion between the supervisor and the

agent may occur when supervision reveals evidence that the agent has pro
duced xL. This is the case either when the agent shirks or when she works hard
and is unlucky. In both of these cases, the agent promises to pay a bribe,
denoted b\, to the supervisor if he reports r = 0 instead of r = xL. If collusion
takes place and the agent pays the promised bribe, her utility is w0 ? b\ if she
has shirked and w0 ? b\ ? y if she has worked but has been unlucky. If instead
collusion does not take place, the agent's utility is wL if she has shirked and
wL ? y if she has worked but has been unlucky. The agent is then ready to form
a coalition with the supervisor if w0 ? b\ > wL, that is, if b\ < w0 ? wL. The
maximum bribe, h , the agent is willing to offer for the uninformative report,
r ? 0, is thus b^=w0 ? w^. Since the supervisor has all the bargaining power,
he can extract b from the agent. Therefore, if the supervisor decides to col
lude with the agent his utility is s0 + kb .
As explained, when supervision reveals evidence that a low output has been
produced, the supervisor has the choice between colluding with the agent,
abusing his power, and not engaging in opportunistic activities. To find his
best move, the supervisor then compares the utilities associated with these
three options. Postponing the analysis of the supervisor's choice between col
luding with the agent and abusing his power to Section 5, we have that when
ever engaging in abuse of power is less lucrative for the supervisor than
colluding with the agent, he has two options left. To make his choice, he then
has to compare the utility sL associated with truthful reporting and the utility
s0 + kb associated with colluding with the agent. We make the standard as

sumption that the supervisor does not engage in opportunistic activities when
he is indifferent. Collusion between the supervisor and the agent will hence not
occur if the supervisor's utility from making a truthful report exceeds his utility
from concealing information, that is, if
sl > s0 + k(w0 - wL), (3)

where w0 - wL is the stake of supervisor-agent collusion. This constraint,
which we refer to as the supervisor?agent no-collusion constraint, expresses
that collusion between the supervisor and the agent can be prevented either by
destroying its stake, that is, by setting w0 = wL, or by creating incentive pay
ments for the supervisor, that is, by setting sL sufficiently large.
4.1.2 Abuse of Power. Abuse of power occurs when supervision reveals ev

idence that a low output has been produced and the supervisor threatens the
principal with concealing this evidence if the principal refuses to comply and
to pay him a tribute. If the principal accepts to comply and to pay the demanded
tribute, denoted tu the supervisor does not conceal the evidence and the prin
cipal then pays wL -f sL + t\ to its employees, whereas if the principal refuses,
the supervisor conceals the evidence and the principal has to pay w0 + s0. The
principal therefore accepts to comply and to pay a tribute if wL + sL + t\ <
w0 + s0. Given that the supervisor has all the bargaining power and the prin
cipal is ready to pay the maximum amount of = w0 + s0 ? wl ? s*l for

truthful reporting, the supervisor can extract from the principal. The tribute
is thus the stake of abuse of power. If the supervisor decides to engage in
abuse of power, his utility is then sl + kt^1.
As noted above, we postpone the analysis of the supervisor's choice be
tween colluding with the agent and abusing his power to Section 5, focusing
here on the supervisor's choice between engaging in abuse of power and direct
truthful reporting, that is, not engaging in opportunism.
Knowing that the supervisor's utilities corresponding, respectively, to direct
truthful reporting and to abusing his power are sL and + kt^, the supervisor
will engage in abuse of power as long as > 0. Indeed, this type of oppor
tunism will take place when > 0. When instead = 0, abuse of power has
no stake and hence will not occur. Therefore, whenever colluding with the
agent is less profitable for the supervisor than abusing his power, the principal
faces a new constraint
h'0 + s0 - wL - sL > 0. (4)

This constraint says that the principal has the choice of two options regard
ing abuse of power. It may either allow this type of opportunism or deter it. If
the principal decides to allow abuse of power, it has to set w0, s0, wl, and sL
such that tfl=w0 -f s0 ? wl ? sl > 0, that is, such that this type of opportun
ism has a stake. The second possible option for the principal is to prevent abuse
of power by destroying its stake. When adopting this preventive option, the
principal thus sets w0, s0, wL, and sL such that t =
w0 + s0 ? wl ? 5"l = 0. Expressed differently, constraint (4) says that when

designing contracts, the principal takes into account that if w0 + s0 ? wL ?
sL > 0, abuse of authority has a stake and hence will take place, whereas if
w0 + s0 ? wL ? 5l = 0 this stake is eliminated.
4.2 Opportunism Related to the Realization of a High Output

When the supervisor obtains hard evidence that a high output has been pro
duced, he has the choice between engaging in one of two possible types
of opportunism and refraining from doing so. We explained above that a
principal-supervisor-agent organization with hard information is exposed
to two types of opportunism related to the realization of a high output, namely
principal?supervisor collusion and abuse of authority.
4.2.1 Principal-Supervisor Collusion. When supervision reveals evidence

that the agent has produced jch, the supervisor may collude with the principal
and report r = 0 instead of r = xH in exchange for a bribe. If the principal does
not collude with the supervisor, it has to pay wH + sH to its employees, whereas
if it colludes with him it has to pay w0 + s0 + b2, where b2 denotes the bribe
paid for information concealment. Accordingly, the principal will collude with
the supervisor if w0 + s0 + b2 < wH + sh- The maximum bribe, b , the prin
cipal is thus ready to pay for information concealment is b =
wh + ? w0 ? s0. Given that the supervisor has all the bargaining power,
he can extract b^1 from the principal. Hence, if the supervisor decides to col
lude with the principal, his utility is s0 + kb\*.

As noted above, when the supervisor obtains hard evidence that production
is xH, he has the choice between colluding with the principal, abusing his
authority, and not engaging in opportunistic activities. To find his best move,
the supervisor then compares the utilities associated with these three options.
Postponing the analysis of the supervisor's choice between colluding with the
principal and abusing his authority to Section 5, we have that whenever col
luding with the principal is more lucrative for the supervisor than engaging in
abuse of authority, he has two options left. To make his choice, he then com
pares the utility sH associated with a truthful report and the utility s0 + kb\*
associated with principal?supervisor collusion. Collusion between the princi
pal and the supervisor will therefore not occur if the supervisor's utility from
making a truthful report exceeds his utility from concealing information, that
is, if
sh > sq + -(wH - w0), (5)

where the stake of principal?supervisor collusion is wH ? w0. This constraint,
which we refer to as the principal-supervisor no-collusion constraint,

expresses that collusion between the principal and the supervisor can be pre
vented either by destroying its stake, that is, by setting wH = w0, or by creating
incentive payments for the supervisor, that is, by setting sH sufficiently large. It
is easy to verify that if the organization is exposed only to principal-supervisor

collusion and k G (0, 1) is sufficiently large, the optimal way of deterring col
lusion between the principal and the supervisor is to set % = w0. Indeed, as
clear from constraint (5), when k is sufficiently large preventing principal
supervisor collusion by creating incentives for the supervisor becomes prohib
itively costly.
4.2.2 Abuse of Authority. Unlike abuse of power, abuse of authority may take
place when supervision reveals evidence that the agent has produced xH. The
supervisor then threatens the agent with reporting r ? 0 if she refuses to com
ply and to pay him a tribute. The agent's utility is wH - t2 ? y if she accepts to
comply and to pay the demanded tribute, denoted t2, and w0 ? y if she refuses.
The agent thus accepts to comply and to pay a tribute for truthful reporting if
wn ? h ? Y > W0 ? y>mat is, if t2 < wn ? w0. Since the supervisor has all the
bargaining power and the agent is ready to pay the maximum amount of
^=wh ? for a truthful report, the supervisor can extract t fr?m me
agent. The tribute t is then the stake of abuse of authority. If the supervisor
decides to engage in abuse of authority, his utility is thus sn + kt .
As noted above, we postpone the analysis of the supervisor's choice be

tween colluding with the principal and abusing his authority to the next sec
tion, focusing in this subsection on the supervisor's choice between engaging
in abuse of authority and direct truthful reporting.
Knowing that the supervisor's utilities corresponding, respectively, to direct
truthful reporting and to abusing his authority are su and sh + Jet , the super
visor will engage in abuse of authority as long as > 0. Indeed, this type of
opportunism will then occur when t > 0.13 When t = 0, abuse of authority
has no stake and hence will not take place.
Thus, whenever colluding with the principal is less profitable for the super
visor than abusing his authority, the principal faces a new constraint
wh ? W0 > 0. (6)
As in the case of abuse of power, this constraint says that the principal has the
choice of two options regarding abuse of authority. It may either allow it or
deter it. If the principal chooses to allow abuse of authority, it sets wH and w0
such that /^=wh ? w0 > 0, that is, such that this type of opportunism has
a stake. If instead the principal chooses to deter abuse of authority, it sets
wH and w0 such that this type of opportunism has no stake, that is, such that
t =wn - W0 = 0. In other words, constraint (6) says that if wu ? w0 > 0,

abuse of authority has a stake and hence will occur, whereas if wH ? w0 = 0
there is no stake for this type of opportunism.
13. Note that we do not account for the possibility of the agent appealing to the principal or
lodging a complaint against her superior. Indeed, the agent cannot prove her allegations if she
decides to lodge a complaint against the supervisor since abuse of authority cannot be observed
and the information provided by the supervisor is the only available information. This accords with
empirical evidence that lodging a complaint is often ineffective. For example, in the case of sexual
harassment, Husbands (1992: 556) writes, "A complaint may encounter a number of practical
obstacles in litigating a sexual harassment case. In pursuing any type of civil case in the countries
surveyed, the burden of proofs falls on the complainant alleging the harassment... the proposition
asserted by the complainant may be difficult to prove in a sexual harassment case. Most propo
sitions for tangible job benefits in exchange for sexual favours are not made with witnesses present,
so it may often be the complainant's word against the alleged harasser's." He then notes, "There is
evidence that a great deal of sexual harassment goes unreported" (538). Another survey by Alfred
Marks (reported in Personnel Today, 13-26 October 1992: 13) claimed that while 88% of respond
ents have experienced sexual harassment at work, 71% of victims do nothing. The individual fears
not being taken seriously, does not want to challenge the seniority of the harasser, or fears reprisals.
As observed by Roberts and Mann (1996: 270): "... most cases of sexual harassment still go un
reported: as many as ninety-five percent of all such incidents may not be brought to light." On this
issue, see also Peirce et al. (1998).
5. Opportunism-Proof Organization
We now turn to the determination of the right constraints regarding opportun
ism. Before proceeding, notice that in the environment under consideration

contracts notably verify that an uninformative report entails a higher wage
for the agent than a report revealing a low output and that an informative report
entails a higher wage for the supervisor than an uninformative one?or for
mally, w0 > wL > 0, sL> s0 > 0, and sH > s0 > 0.14

We have seen that, in the case where supervision reveals evidence that the
agent has produced a low output, the supervisor has three options. He may
collude with the agent, abuse his power, or refrain from engaging in oppor
tunistic activities. From the previous section, we know that the supervisor's
utilities associated with these options are, respectively, s0 + kb , kt^,
and sL. As straightforward to see, we explained above that as long as
> 0 the supervisor will prefer abusing his power and obtaining
5"l + ht^ to direct truthful reporting that yields him sL. We had postponed
the supervisor's choice between abusing his power and colluding with the
agent to this section. Comparing + kt^ and s0 + kb , we have that it is
preferable for the supervisor to abuse his power than to collude with the agent.
Indeed, since k E (0, 1) and recalling that b^=w0 ? wl and tf=w0+
s& ? h'l ? sl, we have sL + k(w0 + s0 - wL ? sL) > s0 + k(w0 ? wL), that
is, sL - s0> k(sL - s0).
The right constraint regarding opportunism in the case where the supervisor
obtains hard evidence that a low output has been produced is therefore con
straint (4). As explained in the previous section, the principal has then the
choice between preventing and allowing abuse of power, that is, between set
ting u>0, 50, wL, and sh such that constraint (4) binds and setting these wages
such that this constraint does not bind.
When supervision reveals evidence that a high output has been produced,
the supervisor again faces three options. We have seen above that in this case
the supervisor may collude with the principal, abuse his authority, or refrain
from engaging in opportunistic activities. The supervisor's utilities associated
with these options are, respectively, s0 + kb\*, s\\ + kt\^, and su. As noted in
the previous section, as long as > 0 it is clearly more interesting for the
supervisor to abuse his authority and obtain sh + kt\* than to directly make
a truthful report and obtain sH. We had postponed the supervisor's choice be
tween abusing his authority and colluding with the principal to this section.
Recalling that ^=wH + sh ~ w0 ~ s0 an(^ ^=wH - w0, we have sh+

kt\* > s0 + kb or, equivalently, sH + k(wH - w0) > s0 + k(wH + sH -
w0 - s0), that is, sH - s0 > k(sH - s0). Abusing his authority is hence more
profitable for the supervisor than colluding with the principal.
14. Notice that setting s0 > sL > 0 and/or s0 > sH > 0, that is, motivating the informed su
pervisor to make an uninformative report, is unrealistic. Furthermore, as can be checked, when
exposed to opportunism it is not possible for the organization to lower its expected cost (derived
below) by setting s0 > sL > 0 and/or s0 > sH > 0 instead of sL > s0 > 0 and su > s0 > 0.
In the case where supervision reveals evidence that the agent has produced
a high output, the right constraint regarding opportunism is thus constraint
(6). As noted above, the principal has then the choice between preventing
and allowing abuse of authority, that is, between setting wu and w0 such that
constraint (6) binds and setting these wages such that this constraint does not
bind.
Definition 1. The form of opportunism that is the most profitable for the
supervisor to engage in is the relevant form of opportunism.
Although the supervisor may engage in four possible types of opportunism,
the types of opportunism to which the organization is really exposed to, and
has to cope with, are abuse of power and abuse of authority.
Hence, the relevant form of opportunism is individual opportunism and the
right constraints regarding opportunism are constraints (4) and (6). There is
thus no need to consider constraint (3), which is the essential constraint of
the large literature on collusion, and constraint (5) when investigating organ
izations exposed to both individual and group opportunism.
Compared to the opportunism-free case considered above, the possibility
of individual opportunism modifies both the agent's incentive compatibility
constraint and the organization's (principal's) objective function. Indeed,

the agent's incentive compatibility constraint becomes /?[7t(wh ?
(1 - n)wL] + (1 -p)w0 - y > pwL + (1 -p)w0 or, since t^=wu - vv0,
w0 - h'lpn
> -. (7)
Given that the supervisor extracts t^=w0 + S0 ? ? s^ > 0 from the pr
cipal, the organization's objective function becomes p[n(wn + 5,h

(1 - 7i)(wL + 5l + ^)] + (1 ~p)(w0 + s&) or, equivalently,pn(wu + sH
(1 -pn)(w0 + s0).
When exposed to opportunism, the program of the organization is thus
[Po] min pn(wH + sH) + (1 -pn)(w0 + s0)

s.t.(2),(4),(6), and (7).
Before solving this program, we define the following.
Definition 2. The relevant form of opportunism is said to be the effective

one if it is optimal to prevent it and if its prevention also deters the other fo
of opportunism.
Definition 3. A pair of contracts ((wL, w0, wH), (sL, s0, sH)) is opportunism
proofif It prevents both group and individual opportunism or, equivalently, if

prevents abuse of power, abuse of authority, supervisor?agent collusion, and
principal-supervisor collusion.
We may therefore define an opportunism-proof organization as an organi
zation that, by offering opportunism-proof contracts, immunizes each of

its members from both engaging in opportunism and being its victim. Differ
ently stated, an opportunism-proof organization is a meritocracy, that is, an
organization with a reward structure based exclusively on professional

achievement.15
Solving program [P0], we have the following.
Proposition 2. (1) The effective, and hence most harmful, form of oppor
tunism in the organization is individual opportunism. (2) The opportunism
proof contracts are (h>l, w0, wh) = (0, y/(pn), y/(pn)) and (sL, s0, su) =
(y/(pn), 0, 0). Both the agent and the supervisor receive a rent.
Proof Lowering wL relaxes constraints without affecting the objective

function, and hence one optimally has wL ? 0. Similarly, given that reducing
Su lowers the expected cost of the organization without making constraints
more severe, one also optimally has su = 0. Rewriting constraint (4) as

s0 > sL ? w0 (since optimally wL = 0), there are then two constraints on
s0: constraint (4) and the limited liability constraint s0 > 0. The principal
has two options. For any w0 > 0, it may set sL e [0, w0] or sL > w0. To op
timally set sL the principal must check which of the two options more nega
tively impacts the optimal choice of s0. If the principal sets sL e [0, w0], the
right constraint on s0 is the limited liability constraint s0 > 0. Since reducing
s0 lowers the expected cost of the organization without making constraints
more severe, the principal then optimally sets s0 ? 0. If, instead, the principal
sets sL > w0, the right constraint on s0 is s0 > 5*l - w0 (>0). Compared to the
other option, this option entails the payment of a strictly positive wage s0 to the
supervisor and thus imposes an extra expected cost on the organization. The
best option is therefore sL G [0, w0] and one optimally has s0 = 0. Once more,
given that reducing w0 lowers the expected cost of the organization without
making constraints more severe, the principal sets w0 as low as allowed by the
agent's incentive compatibility constraint, that is, w0 ? y/(pn) (since optimally
wh = 0). Using the same argument again, it is optimal for the principal to set
wH = w0 (=y/(pn)), that is, to deter abuse of authority. As explained below,
when supervision reveals evidence that the agent has produced a low output,
the principal must pay y/(pn) to the supervisor either through an official or
through an unofficial channel. The principal is therefore indifferent between
15. The major finding of the vast literature on supervisor-agent collusion in hierarchies with an
opportunistic supervisor is that this type of opportunism should be optimally prevented. This result
has been termed the "collusion-proofhess principle". Vafai" (2004b) has extended this result to
the case where the organization is exposed to both supervisor-agent and principal-supervisor
collusion.
any sL in the interval [0, y/(pn)]. For the reasons set out below, the principal
optimally offers sL = y/(pn) and hence deters abuse of power. It is thus optimal
to prevent both types of individual opportunism, that is, constraints (4) and (6)
bind.
Thus far, we have found that the relevant form of opportunism is individual
opportunism and that it should be optimally prevented. To show that this form
of opportunism is the effective form of opportunism, we have to prove that its
prevention also prevents group opportunism.
The examination of constraints (3) and (4) reveals that there are two ways to
deter supervisor?agent collusion and only one way to deter abuse of power.
Indeed, supervisor?agent collusion can be deterred either by destroying its

stake or by creating incentive payments for the supervisor, whereas abuse
of power can only be deterred by destroying its stake. Rewriting constraints
(3) and (4), respectively, as sL ? s0> k(w0 - wL) and s^ ? s0<w0- wL, we
therefore have that preventing supervisor?agent collusion requires that con
tracts satisfy sL ? s0 > k(w0 ? wL) and preventing abuse of power requires
that contracts satisfy sL - s0 = w0 ? wL. Recalling that k G (0, 1) and that
contracts verify w0 > wL > 0, sL > s0 > 0, and sn> s0> 0, we have that
contracts satisfying sL ? s0 = w0 ? wL always satisfy sL ? s0> k(w0 ? wL),
whereas the reverse is not systematically true. Expressed differently, prevent
ing abuse of power always prevents supervisor?agent collusion, whereas the
reverse is not systematically true.
As for opportunism associated with the case where a low output is pro
duced, the investigation of constraints (5) and (6) reveals that there are
two ways to deter principal-supervisor collusion and only one way to deter
abuse of authority. Indeed, collusion between the principal and the supervisor
can be prevented either by destroying its stake or by creating incentive pay
ments for the supervisor, whereas abuse of authority can only be prevented by
destroying its stake. That is, preventing principal?supervisor collusion

requires that contracts satisfy constraint (5) and preventing abuse of authority
requires that contracts satisfy wH = w0. Clearly, given that in our environment
we optimally have su > s0 > 0 and recalling that the principal will always
optimally set s0 = 0, it is straightforward to check that the fact that wu = w0
implies that constraint (5) is always verified (this constraint then becomes
identical to the limited liability constraint sH > 0), whereas the reverse is
not systematically true. In other words, deterring abuse of authority always
deters principal-supervisor collusion, whereas the reverse is not systemati

cally true.
Therefore, given that individual opportunism is optimally prevented, we
have that the effective form of opportunism is this form of opportunism
and that the optimal contracts derived above are opportunism-proof. Q.E.D.
The possibility of abuse of authority reduces the agent's incentive to work.
The principal must then offer w0 = y/(pn) in place of wH = y/(pn) to motivate
the agent to work hard. Given that the expected cost of production and super
vision is increasing in wages paid, it is then clearly preferable for the principal
to prevent abuse of authority by offering wu ? w0 ? y/(pn) than to allow it by
setting wH > w0.16'17A flat wage is thus offered to the agent whenever r ^ jcl.
The agent now receives a rent (1 - p)[y/(pn)].

The principal is then indifferent between contracts that prevent abuse of
power (i.e., contracts with sL = w0 = y/(pn)?since optimally wL = s0 = 0?

and hence t = 0) and contracts that allow this type of opportunism (i.e., contracts
with 0 < sL < w0 = y/(pn), and therefore t > 0). Indeed, knowing that op
timally wL = s0 = 0, the expected cost for the organization of the situation where
the supervisor obtains hard evidence that the agent has produced a low output is
p(\ ? k)(sl + t ) or, equivalently,p{\ ? n)[y/(pn)], that is, (1 ? n)(y/n), since

/f=W0 ? SL and w0 ? y/(pn). Given that in the opportunism-free case the
expected cost for the organization associated with that situation is p(l ? 7i)0,
that is, 0, the possibility of abuse of power imposes an extra expected cost of
(1 ? n)(y/n) on the organization. Expressed differently, whether it decides to
allow or prevent abuse of power, the principal must now pay y/(pn) to the super
visor in the case where supervision reveals evidence that the agent has produced
a low output. The expressionp( 1 ? n)(s^ + t ) tells us that y/(pn) may be paid
either exclusively through an official channel in the form of a wage or exclu
sively through an unofficial channel in the form of a tribute t or, finally, through
both of these channels partially in the form of a wage sL and partially in the form
of a tribute t^.
Before going on with the analysis, notice that when abuse of power is pre
vented (i.e., t = 0), sL enters the principal's objective function. Indeed, the
principal's objective function isp[nwH + (1 ? n)w0] + (1 - p)w0 (given that
optimally wL = su ? s0 ? 0), that is, pnwH + (1 ? pn)w0 or, equivalently,
pnwH + (1 ? pn)sL, since then sL = w0.
If the principal decides to allow abuse of power and sets sL = 0, y/(pn) is
fully paid to the supervisor through an unofficial channel in the form of a tribute
= y/(pn). The supervisor then receives k[y/(pn)] and his rent is p(l ? n)
k[y/(pn)], that is, (1 - n)k(y/n). If the principal decides to allow abuse of
power and sets 5L such that w0 = y/(pn) > sL > 0, y/(pn) is partially paid
through an unofficial channel in the form of a tribute t = y/(pn) - sL
and partially through an official channel in the form of a wage sL. The super
visor then receives sL + k[y/(pn) - sL], that is, k[y/(pn)] + (1 - k)sL, and his
16. As explained above, constraints w0 + s0 ? wL ? sL > 0 and wH ? w0 > 0 are essential to
endogenously determine the optimal options for the principal to cope with abuse of power and
abuse of authority along with the optimal contracts. When these constraints bind, the optimal op
tion is to deter individual opportunistic activities by destroying their stakes rather than to allow
them.
17. Observe that deterring abuse of authority is also optimal in the case where supervision is
costly. If the principal allows abuse of authority by setting wH > w0, the agent receives a "global"
transfer (i.e., a wage packet) out of which she partly or totally "pays" the supervisor. Expressed
differently, the principal pays the supervisor, partially or totally, via the agent. It is then the agent's
tribute that contributes to satisfying the supervisor's incentive compatibility constraint. Allowing
abuse of authority is advantageous for the principal whenever this alternative remuneration system
is less costly than the traditional one (i.e., paying the supervisor directly). Since the side transfer
technology is less efficient than the official one (i.e., k < 1), allowing abuse of authority is then not
optimal.
rent isp(l - n)[k[y/(pn)] + (1 - k)sL] or (1 - n)k(y/n) + p{\ - tc)(1 - k)sL. If

instead the principal decides to prevent abuse of power by setting sL = w0
(=y/(pn)), and thus = 0, y/(pn) is fully paid through an official channel

in the form of a wage sL = y/(pn). The supervisor then receives y/(pn) and
his rent is p(l - n)[y/(pn)], that is, (1 - n)(y/n).

Given that when supervision reveals evidence that the agent has produced
a low output, the principal must pay y/(pn) to the supervisor and is then in
different between allowing and preventing abuse of power, that is, between
any sL in the interval [0, y/(pn)], we naturally assume that it will avoid engag
ing in unofficial transactions. In other words, it will opt for the preventive so
lution and set sL = w0 = y/(pn). Furthermore, our quite natural assumption is
confirmed by the study of the case where supervision is costly. Indeed, in that
case the principal's tribute contributes to satisfying the supervisor's incentive
compatibility constraint. Preventing abuse of power is then strictly beneficial
to the principal. This is because when y/(pn) is paid to the supervisor through
an official channel, he receives it in full since there is then no deadweight loss
associated with the transaction. Notice that, for this same reason, paying the
supervisor through an official channel is also more interesting for him here. As
straightforward to see, the supervisor's rent increases with the part of y/(pn)
paid to him through an official channel. This rent therefore reaches its max
imum when y/(pn) is paid to the supervisor exclusively through an official
channel, that is, when abuse of power is prevented. Our result that individual
opportunism must be prevented is thus robust to the possibility of costly

supervision.
Unlike in the absence of opportunism, both the agent and the supervisor now
receive a rent.18 Since the possibility of individual opportunism increases the
expected cost of the organization from y (in the opportunism-free case) to y +
(1 ? pn)[y/(pn)]?that is, y/(pn)?the expected agency cost associated with

this form of opportunism is hence (1 ? pn)[y/(pn)].
We stressed in the introduction that almost all the literature on opportunism
in three-level hierarchies has focused on collusion between the supervisor and
the agent. To see how the optimal contracts derived in this literature are af
fected if all four possible types of opportunism are considered, let us briefly
18. Note that to prevent abuse of power and abuse of authority, the principal may also destroy
the stakes of these opportunistic activities by setting w0 + s0 ? wL ? sL < 0?that is, sL ? s0 >
w0 - wL?and wH ? w0 < 0?that is, w0 > vvH?instead of w0 + s0 ? wL - sL = 0 and vvH w0 = 0. This does not affect our analysis. Indeed, knowing that k G (0, 1) and that optimally w0 >
wl >O,sl>s0> 0, and sH > s0 > 0, contracts satisfying sL - s0 > w0 - wL always satisfy sL 50 > k(w0 ? wL), whereas the reverse is not systematically true. Similarly, recalling that s0 = 0, it
is easy to check that the fact that w0 > wH implies that constraint (5) is always verified (this con
straint is then less restrictive than the limited liability constraint sH > 0), whereas the reverse is not
systematically true. Clearly, when the principal prevents individual opportunism by setting sL >
+ w0 - wL and w0 > wH, the agent's incentive constraint is constraint (1). The principal then
minimizesp[n(wH + sH) + (1 - tt)(wl + sL)] + (1 - p)(w0 + s0) subjected to constraints (1), (2),
?l > s0 + w0 - wL, and w0 > wH. It is straightforward to verify that the solutions to this program
are the optimal contracts of Proposition 2, which, as stated in that proposition, are preferable to
contracts that allow individual opportunism.
remind the general structure of these contracts in moral hazard environments.

When a three-level organization with an opportunistic supervisor and hard in
formation is exposed only to supervisor?agent collusion, the optimal contracts
must satisfy the no-collusion constraint (3). As in this article, most models of
the existing literature on supervisor-agent collusion with hard information as
sume that all the members of the organization are risk neutral and the super
visor and the agent?whose reservation utilities are normalized to zero?are

protected by limited liability. The collusion-proof contracts offered by the
principal in moral hazard environments exposed only to supervisor?agent col
lusion are then usually such that wH > w0 > wL (=0), sL = kw0, sH = s0 (=0),
whereas the opportunism-proof contracts derived above are such that wn =

W0 > wl (=0), sL = w0, and sH = s0 (=0). Clearly, given that the optimal
wages wH, ?h> and s0 are set at the same levels in an organization exposed
exclusively to supervisor?agent collusion and in an organization exposed to
all four possible types of opportunism, the expected cost of the organization
is higher when all types of opportunism are considered.
Our analysis brings new insights on the functioning of organizations.
As seen above, the only way to deter individual opportunistic activities is to
destroy their stakes. Empirical studies show that many American and Japanese
organizations have actually adopted similar preventive policies (Edwards

1979; Aoki 1988). Destroying the stakes of individual opportunistic activities
affects the supervisor's discretion. We found that the dimension of the super
visor's discretion that is relevant for the organization under the threat of in
dividual opportunism is different from the one that is relevant under the threat
of group opportunism.
It is interesting to observe that whereas supervisor?agent collusion and

abuse of power benefit their instigator, namely the supervisor, abuse of author
ity, paradoxically, does not benefit its instigator. As explained in Vafai' (2002),
given that deterring abuse of authority increases the agent's expected utility
above her reservation utility, the agent is the one who benefits from the super
visor's abuse of authority. In other words, we have the following.
Corollary 1. It is not the instigator (the supervisor) of abuse of authority but
his potential victim (the agent) who captures the informational rent generated
by the possibility of this type of opportunism.

This finding runs against the common belief among economists of organi
zation that those who control the information inside hierarchies appropriate its
rents.
Another interesting result established above is that, unlike for group oppor
tunism, organizations are on an equal footing in terms of policy instruments
when dealing with individual opportunism. Yet, individual opportunism is not
equally harmful in all organizations. The noxiousness of this form of oppor
tunism depends both on the quality of the production technology and on that of
the supervision technology. More precisely, an increase in the quality of the
production technology and/or in that of the supervision technology reduces the
cost of opportunism prevention. Indeed, since dw0/dp = Ow^/dp = ds\Jdp <
0 and dw0/dn = dwn/dn = dsjdn < 0, straightforward comparative statics

reveal that the cost of individual opportunism prevention rises with the in
efficiency of the production technology (i.e., n relatively small) and/or that
of the supervision technology (i.e.,/? relatively small). Individual opportunism
is thus more noxious in hierarchies with a relatively inefficient production tech
nology and/or supervision technology. This is because individual opportunism
prevention goes hand in hand with the agent's incentive pay. The more inef
ficient the production technology and/or the supervision technology, the more
costly it is to induce the agent to work hard?that is, w0 is relatively large?and
hence, given that deterring individual opportunism requires that the principal
sets wH = w0 and sL = w0, the more costly opportunism-proof contracts are.
It is also interesting to note that the noxiousness of individual opportunism is
not dependent on k. This is again due to the fact that there are fewer instru
ments available to the principal to prevent individual opportunism than to pre
vent group opportunism. As stressed, an incentive policy?that is, a policy that
creates incentive payments for the supervisor to report truthfully?consists in
offering the supervisor a utility that outbids the utility he can secure if he
engages in information concealment. Given that there are transaction costs
connected to side contracting, the utility the supervisor can get when engaging
in information concealment is then dependent on k. Hence, when adopting an

incentive policy to deter information concealment the principal offers the su
pervisor a wage which is a function of k. Unlike for group opportunism, an
incentive policy is ineffective against individual opportunism because when
the supervisor engages in this form of opportunism he does not have to trade
off a low wage (i.e., a wage associated with an uninformative report) plus a trib
ute and a high wage (i.e., a wage associated with an informative report) since
he can have both a tribute and a high wage. The only way to deter abuse of
power and abuse of authority is to destroy their stakes. This results in wages
not being dependent on k.
These additional findings are summarized in the following corollary.

Corollary 2. The harmfulness of individual opportunism (1) decreases with
the quality of the production technology and/or that of the supervision tech
nology and (2) is independent of the quality of the side transfer technology.
As noted above, all our assumptions are standard assumptions of the liter
ature on collusion initiated by Tirole (1986). Our main result is based on the
fact that, unlike group opportunism, the only way to deter individual oppor
tunistic activities is to destroy their stakes. This, in turn, prevents group op
portunism. This result remains unaltered as long as the environment

considered is one in which opportunism must be optimally deterred. Indeed,
the analysis of the effective form of opportunism in the sense of the above
Definition 2 is clearly an issue as long as it is not optimal to allow certain

types of opportunism. In particular, this is not anymore the case if a less stan
dard assumption on the supervisor's morals is adopted. In our model, the
supervisor is dishonest or, equivalently, opportunistic. Relaxing this standard

assumption, that is, assuming that the supervisor will not systematically en
gage in opportunism, will sometimes make opportunism prevention subopti
mal. This is, in particular, the case when the probability of the supervisor being
honest is sufficiently high. The argument is then that in the presence of enough
honest supervisors in the economy, costly measures to deter certain opportu
nistic activities are unnecessary, and thus the principal optimally chooses the
tolerance solution. Looking for the effective form of opportunism is then not
an issue. However, even in such an environment, our results continue to hold
for the ranges of parameter values for which all opportunistic activities must be
optimally prevented.
6. Conclusions
In the past quarter of a century, investigations of optimal incentive contracts in
principal?supervisor?agent hierarchies have accounted for the possibility of
a specific type of group opportunism, namely collusion between the supervisor
and the agent. In this research, we have extended the analysis of these hier
archies by allowing the supervisor to engage in various types of group and
individual opportunism. We have characterized the incentive contracts that
optimally immunize principal-supervisor?agent relationships against supervi
sor?agent and principal?supervisor collusion (group opportunism) as well as
abuse of power and abuse of authority (individual opportunism). In so doing,
we have presented a theory of meritocracy.
We have shown that the effective form of opportunism, that is, the form of
opportunism against which the organization should be immunized, is individ
ual opportunism. Therefore, by not considering this form of opportunism, the
incentive contracts literature has given an incomplete picture of the function
ing of organizations.
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Opportunism in Organizations

Author(s): Kouroche Vafa

158 JLEO, V26 N1

This article characterizes the incentive contracts that optimally immunize an or

ganization against the opportunistic activities of its members. We analyze an

whereas group opportunism occurs when the supervisor receives a bribe to

of opportunism is individual opportunism and derive the opportunism-proof

individual and group opportunism.

"The essence of an organization is limitation of the autonomy of all its

Opportunism in Organizations 159

principal?supervisor?agent hierarchies. However, although these hierarchies

by characterizing the optimal incentive contracts that immunize principal

1992) concept of collusion-proofness to the more general concept of

cratic organizations, that is, organizations with a reward structure based

on the difference between the payments?for the other involved party?

4. In the managerial and sociological literatures on organizations, opportunistic activities are

160 The Journal of Law, Economics, & Organization, V26 N1

not always true.

to supervisor?agent collusion and principal-supervisor collusion as group oppor

engage in individual opportunism rather than in group opportunism and that

Opportunism in Organizations 161

of supervisor?agent collusion, is generally the effective type of opportunism in

As suggested by an increasing number of empirical studies and news

possible harmful opportunistic activities that may occur in these models.8

and an outsider (a taxpayer) in a soft information environment. In recent

162 The Journal of Law, Economics, & Organization, V26 N1

The plan of the article is as follows. The principal-supervisor?agent orga

cludes the article.

2.1 Production Technology

2.2 Supervision Technology

publicly verifiable only when the supervisor produces his report.

belongs to / = {xL, 0, jch}, where r = 0 indicates that no evidence has been

Opportunism in Organizations 163

agent's and the supervisor's reservation utilities are normalized to zero. We

for its organization to be valuable. The principal's utility function is then

when r = 0. Similarly, the principal offers a contract (sL, sn) to the

a superior control over his subordinate and power to describe ascendancy

As almost all models of collusion, we consider ex post opportunism, that is,

allowing the supervisor to engage in all possible opportunistic activities to

164 The Journal of Law, Economics, & Organization, V26 N1

authority, as well as two types of group opportunism, namely collusion with

an uninformative report r = 0 in case it refuses to comply and to pay him

the supervisor reports r = 0. If instead the principal accepts to comply, the

Opportunism in Organizations 165

2.5.1 Observability. Opportunism is only observable to the involved parties.

2.5.2 Side Transfer Technology. In accordance with the literature on collu

ample, because opportunistic activities are costly to organize. Transaction

and tributes.11 Notice that if k ? 0, the side transfer technology is totally in

2.5.3 Unofficial Bargaining. Following Tirole (1992) and others, we assume

2.5.4 Unofficial Commitments. In concert with the existing literature on op

portunism in organizations, and more especially Tirole (1992) and Vafai'

ibility of unofficial commitments (i.e., the supervisor's threat to report

166 The Journal of Law, Economics, & Organization, V26 N1

means that no additional assumption is needed to also investigate abuse of

2.6 Sequence of Events

her incentive compatibility constraint is p[nwn + (1 - n)wL] + (1 ? p)w0 ?

This equation makes the agent prefer to exert effort in equilibrium.

(1 - n)wL] + (1 - p)w0 ? y > 0. However, given that transfers must be

negative, the agent's participation constraint is always implied by her inc

wL > 0, w0> 0, wH > 0, sL> 0, s0 > 0, sH> 0. (

Opportunism in Organizations 167

Given that supervision is costless, the supervisor accepts any contract

(sl,S0,sh) G R+. That is, any contract (sl,S0,sh) E is individually

We make the standard assumption that the supervisor reports truthfully