Exit Option in Hierarchical Agency

We explain why organizations that limit the voice of their agents can benefit from granting them an exit option. We study a hierarchy with a principal, a productive supervisor and an agent. Communication is imperfect in that only the supervisor can communicate with the principal, while the agent has no direct voice to the principal. We show that the principal is better off if she grants the agent the option to walk away from the contract. By doing so, the principal is implicitly giving a “veto” power to the agent. This, in turn, restricts the manipulation of report by the supervisor. Thus, the exit option can be interpreted as a remedy for limits on communication. Our finding contrasts to the traditional result from the contract theory literature that the exit option reduces the principal’s welfare, while protecting the agent. Our result is robust to the case under collusion between the supervisor and the agent. We also examine the optimal size of the exit option