ECON 3123: PROBLEM SET 1

PROFESSOR RICHARD HOLDEN

This is due at the start of lecture in Week 4. Late problem sets receive zero credit.

(1) Consider a setting with a risk-averse worker and a risk-neutral rm. The worker puts in some eort level a which the rm does not observe. The workers cost of eort is C (a) = ca2 . Output is given by y = ka + , where is a random variable with E ( ) = 0 and V ar( ) > 0. Firms make workers a take-it-or-leave-it wage oer of the form w = s + by . The rm maximizes its expected net prot E (y w) and the worker maximizes her certainty r V ar(w) ca2 , where r is a measure of equivalent given by CE = E (w) 2 risk-aversion. The workers outside option is 0. (a) Compute E (y ), E (w), and V ar(w). (b) Set up the maximization problem for the rmi.e. write down the objective function, the choice variables and the constraints. (c) Compute the ecient level of eort. Hint: add the rms expected prot and the workers CE and maximize w.r.t. eort. (d) Compute the rms optimal choice of s, b and a when c = 1, r = 1, k = 1, V ar(w) = 1. (e) Compute the rms optimal choice of s, b and a when c = 1, r = 1, k = 1, V ar(w) = 2. (f) Are the eort levels from the two above computations ecient. If not, explain briey why not.

PROFESSOR RICHARD HOLDEN

(2) Consider a setting where there are distortions with a risk-averse worker and a risk-neutral rm. The rms (non contractible) benet function is given by y = f1 a1 + f2 a2 + y , where aj is the workers action/eort on task j , for j = 1, 2. There is another performance measure (which can be contracted on) given by p = g1 a1 + g2 a2 + p . Assume the rm oers a linear contract of the form w = s + bp. Assume that f1 , f2 , g1 , g2 are non-negative and that a2 a2 E ( y ) = E ( p ) = 0. The workers cost of eort is 21 + 22 and her outside option provides utility of u0 . The rm maximizes expected prots and the a2 a2 r worker maximizes her certainty equivalent of E (w) 2 V ar(w) 21 + 22 . (a) Set up the rms constrained optimization problem. (b) Find the optimal level of incentives b. Hint: you may want to make use 2 2 2 2 + f2 g1 + g2 cos. of the formula f1 g1 + f2 g2 = f1 (c) Use the model above (using the parameters of the problem) to discuss the following. There is no correct answer, the key is interpretation. (i) A loan ocer is typically paid based on the volume of loans that she originates (not the performance of those loans), whereas a construction manager is only paid on the successful completion of a project. What reason would the above model oer for these dierent incentive contracts? (ii) Consider a hierarchy with a CEO on top, the division manager below her and a plant manager below the division manager. Various performance measures can be used for a plant manager of a publicly traded rm. The performance measures are the stock price, rm wide accounting prots, divisional prots, plant level prots, and plant level costs. What is the main tradeo shareholders face in designing an incentive scheme for the plant manager?