Linear incentive schemes to control public firms

Abstract

The basic setting of this paper is that of a government and a public firm which pursue different objectives and do not possess the same information. The public manager typically desires the highest compensation for the lowest effort whereas the government's aim is social welfare. Its control of the public firm is hindered by its lack of information on the firm's technology. Given this setting, we deal with a linear compensation rule which is based on variables observed by the government, i.e. labour and output. This rule should be designed to induce the manager to achieve the government's objective as much as possible. The paper focuses on the following issue: how far should the public manager's compensation rule encourage him to hire more or less labour? This is shown to depend upon several factors such as the elasticity of substitution between labour and managerial effort and the output elasticity of the marginal social benefit. A linear schedule is clearly at odds with most findings in the principal-agent literature; it is here adopted for the ease of its practical implementation but by no means does it facilitate the analysis.