Managerial Economics - Essay Example

The major objectives of introducing incentive systems in an organisation are to provide better control over the management as well as to inspire employees to perform operations in a desired manner. Moreover, incentive systems also facilitate in better recruitment as well as management of workforce. Employees of an organisation are provided with various incentive schemes by the organisations that include monetary as well as non-monetary incentives (Magnusson & Nyrenius, 2011). In the financial or banking sector, it has been apparently observed that incentive or compensation system has acquired an important place for the development of these sectors.

Moreover, in the financial sectors, employees are required to take extreme risks for acquiring a better compensation schemes. The salaries of employees in these financial sectors have been identified to be low and thus they are offered with more cash bonus facilities through incentive or compensation schemes. The major purpose of this compensation system is to motivate employees to take excessive risks in the form of asymmetric rewards as well as penalty system (Murphy, 2009). This discussion intends to analyse the principal-agent theory (PAT) in order to identify the issue of incentive system design in relation to financial sectors.

Moreover, the key requirements that an optimal incentive system should possibly meet and the application of the aforementioned theory to the financial sector in order to come up with an efficient compensation contract for bank CEOs will also be portrayed in the discussion. A Brief Study of Principal-Agent Theory (PAT) The significant aspect of PAT principally determines the association between a principal and an agent. The interrelation that exists between principal as well as agent is featured with conflict of objective as well as through asymmetries of information.

PAT usually considers the affiliation between principals as well as agents through varied viewpoints as well as interests. Principals are the individuals who are considered to possess certain formal authority as well as are committed to fulfil organisational targets. Moreover, principals are provided with efficient time resources as well as expertises in order to perform business operations in a proficient manner. Whereas, agents are the individuals who are considered to possess specific objectives as well as expertises for conducting business operations in accordance with determined goals of organisations (Smart, 2010).

The PAT is mainly formulated in mathematical format that has been recognised to be quite complicated as well as composite. In PAT, when a principal is able to observe the extent of effort made by an agent to perform a work, then the principal is required to provide the agent with a forcing contract. In accordance with forcing contract, the principal is obliged to pay the agent a certain amount of money for performing activities on a specific extent of effort. In case, if the agent is unable to perform activities at an expected extent of effort, then he or she will not be paid.

These are certain incentive policies that are based upon symmetrical information (Bolton & et.al., 2005). The PAT considers certain imperative factors that