Differentiate Between Outcome-Oriented Contracts and Behavior-Based Contracts

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The Answer is To reduce agency costs,the agency theory says that the principal must choose a contracting scheme that helps align the interests of the agents with the principal's own interests.These contracts are classified as either behavior-oriented (such as merit pay)or outcome-oriented (e.g.,stock,options,profit sharing).Outcome-oriented contracts increase the risk borne by the agent.Because agents are averse to risk,they may require higher pay to make up for it.Thus,there is a trade-off between risk and incentives that must be considered.Outcome-oriented contracts,for example,are typical for executives.Behavior-based contracts do not transfer risk to the agent and thus do not require a compensating wage differential.However,the principal must either invest in monitoring information on what the agent has done or structure the contract so that pay is linked at least partly to outcomes.

Differentiate Between Outcome-Oriented Contracts and Behavior-Based Contracts

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