A risk-averse manager is hired to run a firm for shareholders. If the manager's effort can be observed and specified in a contract,which would be the best employment contract?
A)a high-powered incentive contract to elicit the most effort.
B)a fixed salary paid as long as the required effort is undertaken.
C)a proportion of profits paid as long as the required effort is undertaken.
D)a wage well in excess of his or her outside opportunity.

Question

Quizplus · Accepted Answer

A risk-averse manager would prefer a fixed salary paid as long as the required effort is undertaken because this type of contract provides a stable income and eliminates the uncertainty associated with incentive contracts. A high-powered incentive contract would introduce risk and be less appealing to a risk-averse manager. While a proportion of profits is an attractive incentive, the variability of profits may be unappealing to a risk-averse manager. A wage well in excess of outside opportunities may be attractive, but it may not be necessary to elicit the required effort if the manager's effort can be specified in the contract. Therefore, a fixed salary paid as long as the required effort is undertaken is the best choice for a risk-averse manager.

A Risk-Averse Manager Is Hired to Run a Firm for Shareholders