It is often, if not typically, impossible to measure accurately an agent’s contribution to firm output, y. As a result, firms may try to find other observable measures, pi, which may be imperfect proxies for y. Suppose both y and p are functions of two observable activities, a2 and a2. Further, the principal believes that y = za1 + za2 but the precise value of z is difficult to estimate. Which proxy value, p, in an incentive plan, w = s + bp, is likely most efficient from the principal’s perspective?
a) p = a1 + 2a2
b) p = a1 + .5a2
c) p = 2a1 + a2
d) p = 2a1 + 2a2
Without fairly precise estimates of z, it is impossible to employ efficiently the relationship