One of the main findings of the principal-agent literature has been that incentive schemes should be sensitive to all information that bears on the agent’s actions. As a manifestation of this principle, incentive schemes tend to take quite complex (non-linear) forms. In contrast, real world schemes are often based on aggregate information with a rather simple structure.
This paper considers the optimality of linear schemes that use only aggregated information. The hypothesis is that linear schemes are to be expected in situations where the agent has a rich set of actions to choose from, because richness in action choice allows the agent to circumvent highly nonlinear schemes. We show that optimal compensation schemes are indeed linear functions of appropriate accounting aggregates in a multi-period model where the agent can observe and respond to his own performance over time. Furthermore, when profits evolve according to a controlled Brownian motion (with the agent at the controls) the optimal compensation scheme is linear in profits. The optimal scheme can be computer as if the principal could only choose among linear rules in a corresponding static problem. Applications of this ad hoc principle appear quite promising and are briefly illustrated.
JEL Classification: 025
Keywords: Intertemporal incentives, Linear incentive schemes
In Holmstrom (1982) an example is given, which shows that a manager’s concern for the value of his human capital will lead to a natural incongruity in risk-preferences between himself and the owners, even when no effort considerations are involved. In this paper we present a formal model of this channel of incongruity based on learning about managerial talent. We also explore the nature of an optimal incentive contract in the case where the manager may withhold but not misrepresent information about investment returns. The optimal contract is an option on the manager’s human capital value with a possible bonus for investing. The optimal investment rule accepts fewer investments than under the cost of capital — a commonly observed real world feature. Another phenomena the model helps explain is the extensive use of capital budgeting and rationing schemes in place of linear or non-linear price decentralization, which are shown to be less efficient modes of allocation.
JEL Classification: 026, 851, 512
Keywords: Incentives, Managerial incentives, Capital budgeting