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It is often, if not typically, impossible to measure accurately an agent’s contribution to firm output, y.

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

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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

 

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