The main focus in the paper is on the second best case. The optimal contracts in this framework are said to be ‘second best’.
Thus, in the presence of this agency problem, the appropriate level of effort is chosen, for any given contract, by the agent in such a way that his expected utility is maximized. On the other hand, in many situations, the principal is not able to enforce the effort level (due to, for example, monitoring costs or lack of observability). The resulting outcome is said to be ‘first best’. If the appropriate level of effort can be specified and enforced by the principal, there is no ‘agency problem’. The agent in turn accepts this contract if and only if he can make himself better off in doing so. The principal (employer) offers to the agent (employee) a contract (which specifies contract length, wage rate and profit sharing schedule) so as to maximize the expected value of a stream of future profits. The model developed is based upon the framework of the principal-agent relationship. In this paper, we present a different point of view one that provides an economic rationale for various practices. Many of the explanations offered so far attribute the difference to cultural, and/or institutional differences in the two countries.
In contrast these practices are relatively infrequent in the United States. Two unique characteristics of modern Japanese labor management practice are the prevalence of lifetime employment and of biannual bonuses.