Unit 6 The firm and its employees

6.6 Getting the work done: Contracts, principals, and agents

For the owners of a firm, recruiting workers is just the beginning of the story. To make profits, they must get the employees to work hard. This leads to conflicts of interest between owners (or their managers) and employees.

Employees join firms because they can do better if they are part of the firm than if they are not. As in all voluntary economic interactions, there are mutual gains. But conflicts arise: between owners and managers about the objectives management should pursue (the separation of ownership and control), and between managers and workers about how the firm uses their time and skills, and especially about how hard they work.

incomplete contract
A contract that does not specify, in a way that can be enforced by a court, every aspect of the exchange that affects the interests of parties to the exchange (or of others).
enforceable contract
A contract is enforceable if it is legally binding. For a contract to be enforceable, a court must be able to establish whether the both parties complied with its terms.
principal–agent relationship, principal–agent problem
A principal–agent relationship or problem exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute, that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract.

As the case of Firestone tyres demonstrates, ensuring that employees work in the interests of the firm’s owners is difficult. Employment contracts are incomplete: they cannot cover everything that the employer and employee care about, such as how hard and well the employee will work, and how long they will stay with the firm. The problem of incomplete contracts arises because:

  • The contract cannot specify exactly what the employee should do in every possible situation; this depends on unforeseen future events.
  • It would be impractical or too costly for the firm to observe exactly how much effort each employee makes in every aspect of the job.
  • Even if the firm could observe effort, it could not be the basis of a contract that would be enforceable in a court of law.
  • The contract cannot prohibit the employee from quitting. (That would be similar to slavery).

A contract is enforceable if it is legally binding. When you pay for a new bicycle, you enter into an enforceable contract with the supplier. If the supplier fails to deliver it, you can go to court to get your money back. To understand why a contract specifying effort would be unenforceable, consider a restaurant owner who would like her staff to serve customers in a pleasant manner. Imagine how difficult it would be for a court to decide whether the owner could withhold wages from a waiter because he had not smiled enough.

Principal–agent problems

The problem of work effort in an employment relationship can be modelled as a principal–agent problem: a game between two players, the principal and the agent, facing a conflict of interest. Here, the employer is the principal and the worker is the agent. The principal would like to offer the agent an employment contract, and the agent wants the job. But there is a conflict of interest: to maximize the firm’s profit, the principal wants the agent to work hard; the agent prefers an easier life.

Principal–agent problems arise in many economic contexts: they are essentially information problems. In this employment example, the problem is a lack of information about exactly what the employee is doing. Information is either asymmetric (the agent knows their own work effort, but the principal doesn’t) or non-verifiable (the principal can observe what the agent is doing, but in most jobs a court would be unable to verify the principal’s account of the employee’s performance). We explore other principal–agent problems in Units 9 and 10.

Verifiable information, asymmetric information

Information is verifiable if it can be used in court to enforce a contract. Non-verifiable information, such as hearsay, cannot be used to enforce contracts.

Information that is known by one party but not another is asymmetric.

Solving the principal–agent problem

An economic reward or punishment, which influences the benefits and costs of alternative courses of action.
piece rate
Under a piece rate contract, a worker is paid a fixed amount for each unit (‘piece’) of the product made.

Since effort cannot be specified in a contract, firms try to provide incentives for employees to work hard. One approach is to offer a contract in which pay depends, at least in part, on what the employee produces. For example, a sales representative may work on commission, receiving a base salary for the time they spend working, plus a bonus that depends on what they sell. Workers at a clothing factory might be paid $2 for each garment they finish. This method of payment, in which pay depends entirely on what the individual produces, is known as piece rate. It gives workers a strong incentive to produce as much as possible.

In the late nineteenth century, the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. By the twenty-first century less than 5% of US manufacturing workers (and even fewer in other sectors) were paid piece rates.1

In modern knowledge- and service-based economies, piece rates are impractical for most types of work. It is difficult to measure the output, particularly for an individual employee—think about someone providing home care for an elderly person or an office worker. In some cases, firms identify teams of workers whose joint output is readily measured—for example, the percentage of on-time departures for airline staff—and reward them for good performance with a payment that is divided among all members of the team. But bonuses based on team performance provide relatively weak incentives for the individual members.

A widely used alternative approach, explained in the following sections of this unit, is to create incentives through employment rents.

Exercise 6.2 Incomplete contracts

Think of two or three jobs with which you are familiar, perhaps a teacher, a retail worker, a nurse, or a police officer.

In each case, indicate why the employment contract is necessarily incomplete. Which important parts of the person’s job—things that the employer would like the employee to do or not do—cannot be covered in a contract, or if they are, cannot be enforced?

Question 6.7 Choose the correct answer(s)

Which of the following are reasons why employment contracts are incomplete?

  • A contract stating that the employee could not leave would not be enforceable.
  • The firm cannot specify every eventuality in a contract.
  • The firm is unable to observe exactly how an employee is fulfilling the contract.
  • The contract is unfinished.
  • It may be costly for the firm if the employee leaves, but employees retain the right to do so.
  • Since the firm does not know all the tasks it will require of an employee, the contract is necessarily incomplete.
  • Since effort or the quality of an individual’s work cannot be perfectly monitored and measured, it cannot be specified in the contract.
  • An incomplete contract is not one that is unfinished, but rather one that does not completely specify every relevant aspect of the employment relationship (which is usually long-term).
  1. Susan Helper, Morris Kleiner, and Yingchun Wang. 2010. ‘Analyzing Compensation Methods in Manufacturing: Piece Rates, Time Rates, or Gain-Sharing?’. NBER Working Papers No. 16540, National Bureau of Economic Research, Inc.