Analysis of Managerial Contracts Under Different Roles of the Human Agent

Several comparative cost management studies in Japan and the U.S., have suggested the superiority of long term managerial contracts using future-oriented measurements in reducing costs and increasing value. In this paper, we show that the optimal length of the contract offered a manager is contextual. In particular, it depends on how the manager's contribution to the firm is perceived. Three distinct roles of a manager are identified - as a provider of effort, as a provider of skills and as a learning agent who can also improve his skills on the job. Using a stylized two period agency model, three types of employment contracts are examined. A pre-commitment contract is where the manager is assured of employment in the second period irrespective of the first period output. A performance contract is where the manager is retained in the second period only if the observed first period output is high. A short term contract is where the manager is replaced irrespective of the first period output.lt;brgt;lt;brgt;The results indicate that if the manager is a provider of effort only, the short term contract is preferred if the measured output in each period depends only on the effort provided in that period and there is some uncertainty on the ability of the firm to support the manager in the second period; otherwise, the pre-commitment contract is preferred. However, if the manager is a provider of skills, the short term contract is sub-optimal. The performance contract is superior to the pre-commitment contract when the output spread is high and the first period output is highly informative about the manager's skill level. Finally, if the manager can also improve his skills and learn on the job by exerting a learning effort, then pre-commitment fosters greater learning and benefits the firm in the long run