Agency Theory

The Tamura International Trading Company plans to hire a manager for its division in Mexico City. Tamura Internationals president and vice president of personnel are trying to decide on an appropriate incentive employment contract. The manager will operate far from the Tokyo corporate headquarters, so evaluation by personal observation will be limited. The president insists that a large incentive to produce profits is necessary; he favors a salary of 150,000 and a bonus of 10% of the profits above 1,200,000. If operations proceed as expected, profits will be 4,600,000, and the manager will receive 490,000. But both profits and compensation might be more or less than planned.

The vice president of personnel responds that 490,000 is more than most of Tamura Internationals division managers make. She is sure that the company can hire a competent manager for a guaranteed salary of 400,000. She argued, Why pay 490,000 when we can probably hire the same person for 400,000?

1. What factors would affect Tamura Internationals choice of employment contract? Include a discussion of the pros and cons of each proposed contract.

2. Why is the expected compensation more with the bonus plan than with the straight salary?