On the optimality of allowing collusion

We examine a model wherein a principal can use an auditor's report to contract with a privately informed manager. The auditor can be honest or dishonest, a fact unknown to the principal who must thus decide whether to allow or deter collusion. Deterring collusion is costly because the principal has to reward both dishonest and honest auditors for refusing a bribe from the manager. Allowing collusion is costly because the dishonest auditors will erode the deterrence of the punishment. We show that the principal may find it optimal to allow collusion. When the punishment is high enough, allowing collusion is always optimal. We also study how collusion is optimally managed in different environments.