An Efficient Bonus Contract

Abstract

Why are bonus/promotion schemes so widely used in reality? Are they effective in alleviating incentive problems? For the standard agency model, this paper proposes an alternative solution to the classical solution in Holmström (1979). The advantages of our solution are that (1) it is a simple solution; (2) it is not based on the troublesome first-order approach; and (3) it is the first best. The disadvantage of our solution is that it imposes a boundary condition on the support of the distribution function. However, this boundary condition does have sensible economic interpretations and our optimal contract resembles the widely observed bonus/promotion scheme in reality. Hence, our solution shows the potential of a bonus/promotion scheme in resolving incentive problems.