Alchian and Demsetz (1972) established that a manager's reward is most efficient if tied to the residual created by the team under his direction. But it is often, if not usually, impossible to measure precisely a manager's contribution to firm output or income, *y*. Gibbons, citing Baker's work, notes that firms may try to find observable measures, *pi, *which may be imperfect but serviceable proxies for y. Suppose both *y *and a set of possible proxies, *pi*, are functions of two activities, a1

and a2 that are under the manager's control.1 Further, our initial research suggests

that *y ≈ za1 + za2*. Which of the hypothetical weights of *pi *for the target incentive system *w = s + bp*, is likely most efficient from the *principal's *perspective?

a. p1 = a1 + 2a2

b. p2 = a1 + .5a2

c. p3 = 2a1 + a2

d. p4 = a1 + a2

e. None of the above pi values and weights can be reasonable proxies for y

#### Top Answer

The answer is... View the full answer