Sunflower Industries has been having problems with the accou

Sunflower Industries has been having problems with the accountability of their managers not being what it should be. Company performance has been slack lately and Sunflower is gearing up for the hire of a new manager. They, however, need to figure out an appropriate manager compensation contract that will increase accountability of the manager. If the manager works hard (a1), net income will be one of $200 or $450 (before manager compensation) with the probability of 0.35, 0.65, respectively. If the manager shirks (a2), net income will be one of $200 or $450 with probability 0.75, 0.25 respectively. The interview with the potential new manager yields that he is rational, risk averse with the utility for money equal to the square root of the amount of money received, and effort averse with the disutility of effort of 2 if he works hard and 0.5 is he shirks. Required: (a) Offered salary is $50 per period plus 20% of firm profits before manager compensation. Will the manager take a1 or a2? (b) Instead, offer salary of $0 plus 30% of firm profits before manager compensation. Will the manager take a1 or a2? (c) Does the manager’s effort decision change between parts (a) and (b)? Why or why not?

Solution

Will the manager take a1 or a2?

for a1       200*0.35 + 450*0.65 = 362.5

for a2        200 * 0.75    + 450 * 0.25 = 262.5

the manager will take a1

(b) Instead, offer salary of $0 plus 30% of firm profits before manager compensation. Will the manager take a1 or a2?

alwas take a1 because $0 plus 30% does not change the result at all

c)

No , because the decision will not change easily