The essence of the principal-agent problem when discussing managerial compensation is the tradeoff that exists between efficiency and risk. Using a simple model of a risk-averse individual, discuss the nature of this trade-off. Be sure to explain what you are showing in your diagram (labeling everything) and explain how various compensation packages lead to different levels of effort and different levels of utility.
One problem with a pure profit-sharing scheme is that managers risk a large fall in income. Using the same model, explain how a stock option can reduce this down-side risk for the agent while achieving the desired outcome for the principal.
Use 3 different compensation schemes: 1. Flat Salary 2. Variable Compensation Scheme 3. Stock Option with strike and spot price.