Dynamic Screening and the Dual Roles of Monitoring

This paper studies monitoring in long-term, self-enforcing relationships with adverse selection and moral hazard. Monitoring is used to screen low types by incentivizing them to shirk. Once high types have been identified, monitoring is used both to incentivize effort from high types and to provide off-path (dis)incentives for low types looking to build a reputation. This results in a key trade-off: providing cost-efficient incentives to high types, versus screening low types faster. The optimal contract uses probation after screening: high types are excessively monitored to facilitate better screening. Monitoring declines as the agent's track record improves. (JEL D11, D82, D86)