The Organization of the Firm 219

initial contract protection against ERUSs going bankrupt, and if the costs of verti-

cally integrating would exceed the likely costs of opportunism due to an incomplete

contract, the manager made the correct decision at the time. Sometimes bad things

happen even when managers make good decisions. If this was not the case, either a

more complete contract should have been written or Big Bird should have decided to

make its own engines.

MANAGERIAL COMPENSATION AND THE PRINCIPALAGENT PROBLEM

You now know the principal factors in selecting the best method of acquiring inputs.

Our remaining task in this chapter is to explain how to compensate labor inputs to

ensure that they put forth their best effort. After completing this section you will

better understand why restaurants rely on tips to compensate employees, why secre-

taries usually are paid an hourly wage, and even why textbook authors are paid roy-

alties. We will begin, however, by examining managerial compensation.

One characteristic of many large firms is the separation of ownership and control:

The owners of the firm often are distantly located stockholders, and the firm is run on

a day-to-day basis by a manager. The fact that the firms owners are not physically

present to monitor the manager creates a fundamental incentive problem. Suppose the

owners pay the manager a salary of $50,000 per year to manage the firm. Since the

owners cannot monitor the managers effort, if the firm has lost $1 million by years

end, they will not know whether the fault lies with the manager or with bad luck.

Uncertainty regarding whether low profits are due to low demand or to low effort by

the manager makes it difficult for the owners to determine precisely why profits are

low. Even if the fault lies with the managerperhaps he or she never showed up at the

plant but instead took an extended fishing tripthe manager can claim it was just a

bad year. The manager might say, You should be very glad you hired me as your

manager. Had I not worked 18-hour days, your company would have lost twice the

amount it did. I was lucky to keep our loss to its current level, but I am confident things

will improve next year when our new product line hits the market. Since the owners

are not present at the firm, they will not know the true reason for the low profits.

By creating a firm, an owner enjoys the benefits of reduced transaction costs.

But when ownership is separated from control, the principalagent problem emerges:

If the owner is not present to monitor the manager, how can she get the manager to

do what is in her best interest?

The essence of the problem is that the manager likes to earn income, but he also

likes to consume leisure. Clearly, if the manager spent every waking hour on the

job, he would be unable to consume any leisure. But the less time he spends on the

job, the more time he has for ball games, fishing trips, and other activities that he

values. The job description indicates that the manager is supposed to spend eight

hours per day on the job. The important question, from the owners point of view, is

how much leisure (shirking) the manager will consume while on the job. Shirking

may take the form of excessive coffee breaks, long lunch hours, leaving work early,

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220 Managerial Economics and Business Strategy

TABLE 61 Managerial Earnings and Firm Profits under a Fixed Salary

Hours Worked Hours Shirked

Managers Earnings by Manager by Manager Profits of Firm

$50,000 8 0 $3,000,000

50,000 7 1 2,950,000

50,000 6 2 2,800,000

50,000 5 3 2,500,000

50,000 4 4 2,000,000

50,000 3 5 1,800,000

50,000 2 6 1,300,000

50,000 1 7 700,000

50,000 0 8 0

or, in the extreme case, not showing up on the job at all. Note that while the man-

ager enjoys shirking, the owner wants the manager to work hard to enhance profits.

When the manager is offered a fixed salary of $50,000 and the owner is not phys-

ically present at the workplace, he will receive the same $50,000 regardless of whether

he works a full eight hours (hence, doesnt shirk) or spends the entire day at home

(shirks eight hours). This situation is illustrated in Table 61. From the point of view of

the owner, the fixed salary does not give the manager a strong incentive to monitor the

other employees, and this has an adverse effect on the firms profits. For example, as

Table 61 shows, if the manager spends the entire day on the job monitoring the other

employees (i.e., making sure that they put out maximum effort), shirking is zero and

the firms profits are $3 million. If the manager spends the entire day shirking, profits

are zero. If the manager shirks two hours and thus works six hours, the firms profits

are $2.8 million. Since the fixed salary of $50,000 provides the manager with the same

income regardless of his effort level, he has a strong incentive to shirk eight hours. In

this case the profits of the firm are zero but the manager still earns $50,000.

How can the owner of the firm get the manager to spend time monitoring the

production process? You might think if she paid the manager a higher salary, the

manager would work harder. But this will not work when the owner cannot observe

the managers effort; the employment contract is such that there is absolutely no

cost to the manager of shirking. Many managers would prefer to earn money with-

out having to work for it, and such a contract allows this manager to do just that.

Suppose the owner of the firm offers the manager the following incentive contract:

The manager is to receive 10 percent of profits (gross of managerial compensation)

earned by the firm. Table 62 summarizes the implications of such a contract. Note that

if the manager spends eight hours shirking, profits are zero and the manager earns noth-

ing. But if the manager does not shirk at all, the firm earns $3 million in gross profits

and the manager receives compensation equal to 10 percent of those profits: $300,000.

Exactly what the manager does under the profit-sharing compensation scheme

depends on his preferences for leisure and money. But one thing is clear: If the

manager wants to earn income, he cannot shirk the entire day. The manager faces

a trade-off: He can consume more leisure on the job, but at a cost of lower

compensation. For example, suppose the manager has carefully evaluated the

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The Organization of the Firm 221

TABLE 62 Managerial Earnings and Firm Profits with Profit Sharing

Hours Worked Hours Shirked Gross Profits for Managers Share of

by Manager by Manager Firm (p) Profits (.10 3 p)

8 0 $3,000,000 $300,000

7 1 2,950,000 295,000

6 2 2,800,000 280,000

5 3 2,500,000 250,000

4 4 2,000,000 200,000

3 5 1,800,000 180,000

2 6 1,300,000 130,000

1 7 700,000 70,000

0 8 0 0

trade-off between leisure on the job and income in Table 62 and wishes to earn

$250,000. He can achieve this by working five hours instead of shirking all day.

What is the impact of the profit-sharing plan on the owner of the firm? The man-

ager has decided to work five hours to earn $250,000 in compensation. The five

hours of managerial effort generate $2.5 million in gross profits for the firm.

Thus, by making managerial compensation dependent on performance, the gross

profits for the owner rise from zero (under the fixed-salary arrangement) to $2.5

million. Note that even after deducting the managers compensation, the owner

ends up with a hefty $2,500,000 $250,000 5 $2.25 million in profits. The per-

formance bonus has increased not only the managers earnings, but also the

owners net profits.

FORCES THAT DISCIPLINE MANAGERS

Incentive Contracts

Typically the chief executive officer of a corporation receives stock options and

other bonuses directly related to profits. It may be tempting to argue that a CEO

who earns over $1 million per year is receiving excessive compensation. What is

important, however, is how the executive earns the $1 million. If the earnings are

due largely to a performance bonus, it could be a big mistake to reduce the execu-

tives compensation. This point is important, because the media often imply that it

is unfair to heavily reward CEOs of major corporations. Remember, however, that

performance-based rewards benefit stockholders as well as CEOs, and reducing

such rewards may result in declining profits for the firm.

Demonstration Problem 65

You are attending the annual stockholders meeting of PIC Company. A fellow shareholder

points out that the manager of PIC earned $100,000 last year, while the manager of a rival

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222 Managerial Economics and Business Strategy

firm, CUP Enterprises, earned only $50,000. A motion is made to lower the salary of PICs

manager. Given only this information, what should you do?

Answer:

There is not enough information to make an informed decision about the appropriate way to

vote; you should ask for additional information. If none is forthcoming, you should move to

table the motion until shareholders can obtain additional information about such things as

the profits and sales of the two firms, how much of each managers earnings is due to profit

sharing and performance bonuses, and the like. Explain to the other shareholders that the

optimal contract will reward the manager for high profits; if PICs managers high earnings

are due to a huge performance bonus paid because of high profits, eliminating the bonus

would not be prudent. On the other hand, if CUPs manager has generated larger profits for

that firm than your manager has for PIC, you may wish to adjust your managers contract to

reflect incentives similar to those of the rival firm or even attempt to hire CUPs manager to

work for PIC.

External Incentives

The preceding analysis focused on factors within the firm that provide the manager

with an incentive to maximize profits. In addition, forces outside the firm often pro-

vide managers with an incentive to maximize profits.

ReputationManagers have increased job mobility when they can demonstrate to other firms

that they have the managerial skills needed to maximize profits. It is costly to be

an effective manager; many hours must be spent supervising workers and plan-

ning production outlays. These costs represent an investment by the manager in

a reputation for being an excellent manager. In the long run, this reputation can

be sold at a premium in the market for managers, where other firms compete for

the right to hire the best managers. Thus, even when the employment contract

does not explicitly include a performance bonus, a manager may choose to do a

good job of running the firm if he or she wishes to work for another firm at some

future date.

TakeoversAnother external force that provides managers with an incentive to maximize profits is

the threat of a takeover. If a manager is not operating the firm in a profit-maximizing

manner, investors will attempt to buy the firm and replace management with new

managers who will. By installing a better manager, the firms profits will rise and

the value of the firms stock will increase. Thus, one cost to a manager of doing a

poor job of running the firm is the increased likelihood of a takeover. To avoid paying

this cost, managers will work harder than they otherwise would, even if they are

paid only a fixed salary.

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