Firms often pay managers a percent of profits to encourage them to work longer hours for the company. Managers are often conflicted by the desire for extra income and the reduction of leisure time for family and personal enjoyment. Consider the following example. When the manager is paid a salary of $100,000 without a share of profits, she spends the minimum required time at work and maximizes her leisure time. When the manager is paid $100,000 plus a small percent of profits she increases the time spent at work. Her average income increases to $120,000.
Can you tell from this example whether the manager has shown a preference for the second compensation scheme? If so, has the company benefited from the second compensation scheme?
As we can see from this example, the manager has shown a preference for the second compensation scheme, becouse his amount of income now depends on his activity and the profits of the company. So, the company benefited from the second compensation scheme, because its profits will rise, as the manager spends more time to work harder to receive the higher income.