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Incentives, Team Production, Transaction Costs, and the Optimal Contract: Estimates of an Agency Model using Payroll Records

By Christopher Ferrall and Bruce Shearer

Abstract

We apply agency theory to the payroll records of a copper mine that paid a production bonus to teams of workers. As with most incentive pay used by firms, the bonus was simpler in form than the optimal contract that balances incentives, insurance, and free-riding. We explore whether transactions costs help explain this discrepancy. We estimate an agency model for the payroll data using the method of maximum likelihood and find that incentives and free-riding within teams accounted for two-thirds of the bonus system's inefficiency relative to potential full information profits. The remaining one-third of the inefficiency is attributed to the form of the incentive contract as constrained by transactions costs. We discuss alternative explanations and the general empirical content of agency theory.principal-agent models, transactions costs, performance pay, maximum likelihood estimation

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