Prevolio
Game theoryClassroom · multi-user

Design a Contract — Incentives & Effort

Paired up, an Employer designs a pay scheme (fixed wage + profit share) and a Worker chooses how hard to work. See why pay is structured the way it is when effort is hidden.

You’ll learn: See why employers can't simply pay for effort they can't observe, and how the mix of fixed wage and profit share trades off risk-sharing against incentives.

Teacher guide

Students will learn to

  • Experience both sides of an employment contract: designing pay, and responding to it.
  • See how effort responds to the strength of the incentive (the profit share).
  • Understand the trade-off between sharing risk and motivating effort under hidden action.

Before the session — ask

  • If you couldn't watch how hard your worker tried, how would you pay them?
  • As a worker on a flat salary, what's your incentive to work harder than the minimum?

After the session — discuss

  • Did higher profit shares lead to higher effort across the pairs?
  • Who bore the risk when output depended partly on luck — the employer or the worker?
  • Where do real jobs use salary vs. commission vs. equity, and why?

Timing

  • Briefing & pairing3–5 min
  • Design & effort4–6 min
  • Reveal & discussion8–10 min

Run it with your class

Students join with a code or QR — no account needed. Teachers start a session from the dashboard.

Join with a codeFor teachers

What is the principal-agent problem?

The principal-agent problem arises whenever one person (the principal) hires another (the agent) to act on their behalf, but can't fully observe how hard the agent actually works. Because effort is hidden, the agent may have an incentive to shirk — do less than the principal would want — a situation economists call moral hazard or hidden action. An employer can't simply 'pay for effort' they can't see, so they have to design a contract that ties pay to something observable, usually the results the effort produces. That is why compensation is often a mix of a fixed wage plus a share of profit (or a bonus, commission, or equity): the fixed part gives security, and the variable part rewards outcomes to motivate effort. But this creates a real tension — the risk-versus-incentives trade-off. Loading pay onto results sharpens incentives but dumps risk onto the agent, who suffers when outcomes are bad for reasons outside their control; a flat wage removes that risk but kills the incentive to try hard. The best contract balances the two. It's the core logic behind how salaries, bonuses, commissions, and equity are structured across the economy.

How the simulation shows it

Paired up, an Employer designs a pay scheme — a fixed wage plus a profit share — and a Worker chooses how hard to work when effort is hidden. Playing either role shows why pay is structured the way it is: too flat and the worker coasts; too risky and it punishes them for bad luck, so the contract has to balance incentives against risk.

Common misconceptions

Frequently asked questions

What is the principal-agent problem?
The difficulty that arises when a principal hires an agent to act for them but can't observe the agent's effort, so the agent may not act fully in the principal's interest.
What is moral hazard?
The incentive to take less care or effort when the consequences fall partly on someone else and your action is hidden — here, a worker shirking because effort can't be observed.
Why is pay a mix of fixed wage and profit share?
Because effort is hidden, pay is tied to observable results. A fixed wage gives security while a profit share (or bonus) rewards outcomes, motivating effort the employer can't directly see.
What is the risk-incentives trade-off?
Tying pay to results strengthens incentives but forces the agent to bear outcome risk they don't fully control. More incentive means more risk, so the best contract balances the two.
Where does this show up in real life?
In how salaries, bonuses, sales commissions, and equity are designed — and in insurance, landlord-tenant, and shareholder-manager relationships wherever effort or care is hard to observe.

Related concepts