Question

Why is manager effort usually unobservable to the firm's owners

Answer 1

Solution:

The manager’s effort is usually unobservable because of the complex and broadly defined nature of manager effort. As a result, when the owner and manager are different person or unless the firm is very small, it is effectively impossible for a firm owner or shareholders to observe whether the manager is working hard or shirking.

- This is moral hazard

- A straight salary means that their compensation does not rely on effort and there is no compensation risk, therefore unmotivated to work hard.