OPERATING EFFICIENCY AND OUTPUT INSENSITIVE EMPLOYMENT CONTRACTS FOR CAPITAL MANAGEMENT

This paper considers a problem in which an agent is hired to manage a capital investment and subsequently receives private information regar ding the productivity of the capital investment. The capital manager m ust decide whether to invest capital supplied by the firm (the princip al), or to divert these investment funds to perquisite consumption. If the manager decides to invest, the manager must then select the level of operating efficiency (productivity) of the capital investment, thi s latter choice being unobservable and constrained by the (maximal) pr oductivity of the investment. In this setting we demonstrate that the optimal employment contract, from the perspective of the firm hiring t he manager, is the contract which minimizes the dependence of the mana ger's compensation on firm output. This contract pays the manager a fi xed wage whenever output from the investment exceeds the wage and prov ides the manager with all of the projects rents whenever output falls below this level. Thus, we provide a setting in which fixed wage contr acts are the optimal incentive contract even when agents are risk neut ral and contracts can be costlessly written on future output.