2. Fashioning Incentive Contracts for Managers Such contracts may be implicit or explicit Such contracts may be implicit or explicit We’re talking here about a part of the firm’s reward systems, which is a part of organizational architecture. We’re talking here about a part of the firm’s reward systems, which is a part of organizational architecture.

3. Fashioning Incentive Contracts for Managers The idea here is to permit CEOs to choose their own compensation, a mix of income and perquisites, according to their own preferences. The idea here is to permit CEOs to choose their own compensation, a mix of income and perquisites, according to their own preferences.

4. Fashioning Incentive Contracts for Managers The utilitiy of the CEO, U, is derived from The utilitiy of the CEO, U, is derived from Monetary compensation, C Monetary compensation, C Perquisites, P Perquisites, P Thus, U = f (C,P) Thus, U = f (C,P)

5. Fashioning Incentive Contracts for Managers Often, CEOs can extract some perquisites covertly by deducting them from unreported profits, which represents a moral hazard problem. Often, CEOs can extract some perquisites covertly by deducting them from unreported profits, which represents a moral hazard problem.

6. Fashioning Incentive Contracts for Managers We will assume the owners know the profit potential, Πp, and that the CEO is paid salary, S, without perquisites. Thus, realized profit, Πr = Πp – P We will assume the owners know the profit potential, Πp, and that the CEO is paid salary, S, without perquisites. Thus, realized profit, Πr = Πp – P With this information, the CEO will be permitted to take perqs as part of regular compensation, and the owners will contract to deduct them from his salary. With this information, the CEO will be permitted to take perqs as part of regular compensation, and the owners will contract to deduct them from his salary.

7. Fashioning Incentive Contracts for Managers Perqs will still be advantageous. The manager makes his own choices and perqs are not always taxed. Perqs will still be advantageous. The manager makes his own choices and perqs are not always taxed.

8. The Compensation Contract The CEO will be offered this compensation contract, which solves the potential incentive problem for the owners. The CEO will be offered this compensation contract, which solves the potential incentive problem for the owners. C = S – ( Πp - Πr )

9. The Compensation Contract This contract reduces the salary by the full cost of the perquisites consumed by the CEO. This contract reduces the salary by the full cost of the perquisites consumed by the CEO. C = S – P

10. The Compensation Contract So the CEO has the choice of taking more P and less C, or vice versa.

11. The Compensation Contract This is how the choice looks using indifference analysis for the choice of C* and P*. This is how the choice looks using indifference analysis for the choice of C* and P*. P($) C($) P* C*

12. The Compensation Contract The CEO is better off making the choice he or she prefers The CEO is better off making the choice he or she prefers The owners always just pay the same amount, The owners always just pay the same amount, in whatever form. in whatever form. P($) C($) P* C*