Incentive Provision and Risk Bearing: The Applicability of Contract Theory Reconsidered I
Japanese companies once tried introducing performance-based reward system but could not make it work well, and many of those companies eventually abolished it. Someone pointed out that performance-based reward system was not compatible with employment practices and corporate culture of Japanese companies. Many Japanese companies are, however, currently faced with a management problem of combined use of job-based employment and membership-based employment. This case material gives a numerical example of a simple employment contract for clarifying the tradeoff between incentive provision by a firm and risk bearing by a worker in a situation where moral hazard occurs. The aim of this material is to illustrate a solid formulation based on the theory of contract in order to seek for precise conditions under which an incentive contract for employment works. The mathematical knowledge that the discussion in this case material requires of the readers is the derivative of the function $y=x^2$. The readers who can find the minimum value of a quadratic function may read through the text without knowing the derivative.