The Simple Analytics of the Principle-Agent Incentive Contract

The traditional theory of the firm, as presented in virtually all economics textbooks, implicitly treats the firm as an owner-managed, or entrepreneurial, entity. In reality, ownership and control of the firm are often separated. The consequent delegation of tasks and information asymmetry lead to a principal-agent problem whereby managers may not act in the best interests of the owners. Essentially, if the owners are unable to completely monitor the action of the managers, effort-averse managers are likely to shirk- to pursue their own objectives rather than those of the owners. Shareholders derive utility from profits, and perhaps disutility from risk; managers derive utility from salary, bonus, and prerequisites, disutility from managerial effort, and perhaps disutility from the risk associated with potential variability of the bonus. In order to motivate managers to act in the best interests of the shareholders, owners must offer managers incentive contracts that provide a financial offset to the disutility of work and align the managers’ efforts with the objectives of the owners.