Abstract: This paper analyzes the interaction between two different internal mechanisms of the firm. We derive the optimal contract and analyze it when a managerial compensation scheme contingent to the firm's performance and a monitoring device are available. We show that in the regions where the optimal contract does not achieve the first best effort, it is always optimal to implement a positive level of monitoring. We also find that ownership structure becomes relevant in determining the optimal contract.
We also make an attempt to model a Code of Best Practice. We consider that a Code of Best Practice can be understood as a monitoring technology. We find out that some firms may optimally choose not to adopt the Code because they are providing better incentives. Other firms may adopt the Code, but not always use it to reach more efficient outcomes.

Keywords: Code of Best Practice; Monitoring, Limited Liability

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