MANAGERIAL INCENTIVES - ON THE NEAR LINEARITY OF OPTIMAL COMPENSATION

Contracts are examined when outcomes depend on managers' choices as we ll as efforts. As the cost of effort shrinks relative to payoffs, the optimal contract converges to a linear payoff if the control space of the agent has full dimensionality, but not otherwise. Thus, when the a gent can trade expected return for greater correlation with other retu rns, it is better to ignore relative performance when the cost of effo rt is small. When the choices include all fair gambles and hedges, the linear schedule is no more expensive than any other schedule that ind uces effort. Unfair gambles are examined as well.