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19.2: Cost of Providing Incentives
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- How much does it cost to motivate agents?
- The principal chooses the salary to minimize the cost of the agent; thus, the principal nets the total output, minus the cost of the agent.
- The agent’s cost must be at least as large as what the agent would get in an alternative occupation and thus includes a risk adjustment.
- The optimal commission offered by the principal is decreasing in the risk aversion of the agent and the level of risk and increasing in the agent’s ability.
- If the agent is neutral to risk, the principal gets a lump sum, and “sells the agency.”
- Total output falls as the costs of risk rise.
- A company that puts more of the compensation in the form of commission tends to attract more able agents and agents less averse to risk. A principal must not only consider the incentive to work hard created by the commission and salary structure but also the type of agent who would choose to accept such a contract.
- Describe how a principal would go about hiring agents who are willing to take risks.