A major issue in many areas of business decision-making is the principal-agent problem. One example is the owner-manager separation common in many firms.

(a) Briefly explain this issue and how owners try to incentivize managers to work rather than shirk (i.e. using their work time for leisure activities)?

(b) In terms of the salary-shirking trade-off show the opportunity set for a manager with a guaranteed fixed salary of £100,000 per year. Assuming traditional smooth convex indifference curves, explain how the manager's optimal mix of salary and leisure (i.e. shirking) are obtained. You may assume a working day of 8 hours?

(c) An alternative is for the owner to offer a salary component that varies with the success (profit) of the firm. The firm decides to pay the manager a fixed salary of £50,000 with an added bonus of 1% of company profits. The expected relationship between the manager's daily work input and the firm's profits is as follows:

Manager's work input per day (hours)	Firm's profit (£ million)
0	0
1	1m
2	2m
3	3m
4	4m
5	5m
6	6m
7	7m
8	8m

In terms of the salary-shirking trade-off show the opportunity set for a manager with a guaranteed fixed salary of £100,000 per year. Assuming traditional smooth convex indifference curves, explain why this scenario is more likely to result in a different mix of salary and leisure (i.e. shirking) than the fixed salary? 

Answer rating: 100% (QA)

a The principalagent problem occurs when the goals of the person making a decision the agent are not ... View the full answer