The Economy of High Wages: An Agency Problem

latitude with respect to the effort they supply, and monitoring of effort and output is costly. In this paper we examine the agency problem that arises in these circumstances. The agent (employee) is assumed to maximize expected utility, which depends on wages and effort (a "bad"). We assume that output is a deterministic function of effort, that either effort or output can be accurately monitored, and that monitoring is costly. The firm's problem is to select a level of monitoring and a compensation package that will minimize the cost of obtaining a desired level of effort, given the cost of monitoring, the agent's preferences and the agent's opportunity cost of accepting employment with the firm (his labour supply constraint). The firm chooses a compensation scheme from the set in which compensation is contingent on effort if the agent is monitored, and is equal to a standard