Incentive-based compensation to advertising agencies: A principal-agent approach

Using the agency theory, we study the optimal incentive-based compensation contract that the advertiser should offer to the advertising agency. We show that, when the overall risk level is moderate, more incentive should be used as the risk level increases. However, as the risk level is sufficiently high, more fixed fees and less incentive should be used. We also find that there is a roughly N-shaped relationship between incentive rate and ad budget. Specifically, for either a small or large budget, more incentive should be used; and for a moderate budget, less incentive should be used.