An optimal scheme is one that gives the employer the highest expected profit net of compensation paid, subject to the constraint that the employee must be given compensation package attractive enough to get him to accept the job.
1 - The optimal compensation scheme for the employee will typically involve him getting more compensation the greater is x. But, at the same time, he will not bear the risk of the venture: He will be guaranteed a base wage, even if x = O.
2. In general, the wholly optimal compensation scheme is a complicated function of x. But if we restrict attention to more realistic and simpler compensation schemes where the employee is paid a base wage of B and a bonus of b per unit of x produced, we typically find that B is greater than zero and b is smaller than the "full "value of a unit of output to the employer.
3. In some instances, the value of the services provided to the employer may not be known when it comes time to pay off the employee. For example, the branch manager of a bank may decide on loans to make, and it will take years to discover whether those loans perform well or not. In such cases, incentive payments can and should be made on the basis of any observable variable that is statistically related to the value of the services provided. For example, a branch manager may have her compensation based on the quality of a randomly selected sample of loans that she makes, where the quality of one of those loans is determined by independent examiners.
4. Other things held equal, incentive compensation works better the better (less noisy) the compensation-linked variable is as a signal about the employee's level of effort e.
5 - In formal models, the employee likes money and dislikes effort, and the employee motivates higher levels of distasteful effort by offering higher levels of income for better outcomes. There is nothing in the formal theory, however, that mandates that compensation is the only motivator. Promotion, power, autonomy, the esteem of co-workers, and the ability to remain employed-to enjoy the work atmosphere, to maintain enjoyable social relations, to keep one's children in the same schools-are all tangible things that employees value to varying degrees. Thus, any and all of these can motivate employees. (There are also intangibles - such as pride in one's work, interest in the work itself, and the psychological need to justify to one actions previously taken - that go into the creation of intrinsic motivation.) When applying these ideas, the employer must consider the net effect of all the motivators, including intrinsic motivators. And specific problems accompaniment specific motivational devices, particularly promotion.
The basic principal-agent model asserts the employee is effort averse, and the point of incentives is to get the employee to exert himself. Employees will fill their working time with some mix of activities, activities at which they will work quite hard without specific extrinsic incentives. The employer's problem is to motivate them to choose the particular mix of activities that the firm would like to have done. Very few people complain, for instance, that the problem with elected government officials is that they are not doing anything; rather, the complaints seem to be that they are doing the wrong things!
Incentive schemes that reward only one activity or one particular class of activities can have unpleasant effects. For example, an incentive scheme that rewards a salesman based on the volume of sales may cause the salesperson to devote too much energy to repeat sales and not enough to developing new clients.
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