Econ: Principal-agent Problem and Effort Essay

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Compensation
Principal-Agent Problem
Principal is the owner of the company – has a certain objective – max shareholder value
Agent is the manager – has different objective:
Max their income, but minimize risk and effect

Very simple principal agent model – assume no risk
To achieve a target level of profit (pi), a certain amount of effect must be expended by manager
Effect = many aspects of job that are desirable and many that are not
Want to design the compensation of the manager to max profits, realizing that how we design that compensation affects effort and therefore profits
Profits (e) = revenue – costs
Profits affected by effort of manager

Manager wants to maximize income and minimize effort
As effort increases, the manager incurs increasing disutility
Utility = satisfaction, disutility = dissatisfaction
Manager is max the net benefit of the job
B(e) = S – u(e) u(e) – disutility of effort b(e) – net benefit
S - Salary

(see graph in notes) – max of B€ is “0” effort

Suppose owners can observe effort
Spying on agent
Not desired outcome
Instead, use some proxy of effort
Principal needs to structure compensation to increase effort – by rendering effort based on some related measure of profits
Compensation now: S (e) = K + V(e)
S – Salary
K – Fixed salary
V – Variable salary that increases effort e - effort
Firm: Pi (e) = R (e) – S (e) – C
Take derivative with respect to e – marginal benefit from increase effort > 0
(see graph)
From manager’s perspective, manager still maximizing the net benefits from employment
B(e) = K + V(e) – u(e)
You completely compensate the disutility of effort with this variable compensation package ( allows principal to choose e*)
Recap:
1. since the agents actions are guided by the comparison of the benefits and costs of employment (benefits = income, costs = effort), changing the level of pay does not affect the employees level of effort – which is why we need variable compensation
2. If profit sharing = 100% (of profit) – agent becomes the owner, this would be incentive compatible. In most cases, individuals chooses effort bases on marginal benefits and marginal
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