Econ 2105 Economics of Corporations Suraj Prasad Session 2, 2010 Problem Set 3 1.

Consider a model with distortions with a risk averse worker and a risk neutral rm. The rms benet (not contractible) is given by y = f1 a1 + f2 a2 + y where aj is the workers action/eort in task j, j = 1, 2. There is another performance measure (which can be contracted on) given by p = g1 a1 + g2 a2 + p . Firms oer linear contracts given by w = s + bp. Assume that f1 , f2 , g1 , g2 are non-negative and that E ( y ) = 1 2 1 E ( p ) = 0. A workers cost of eort is a2 1 + a2 and his outside option 2 2 gives him a utility level of u0 . The rm maximizes expected prots and the worker maximizes his certainty equivalent given by CE = 1 2 1 1 E (w) rV ar(w) a2 1 a2 . 2 2 2 (a) Set up the rms constrained maximization problem. (b) Find the optimal level of incentives, b. You can use the formula 2 2 2 2 that f1 g1 + f2 g2 = f1 + f2 g1 + g2 cos. (c) Use the model above (using parameters of the problem) to discuss the following points. There is no correct answer. Interpretation is important here. I want you to stare hard at the formula and then based on the parameters give short 1 or 2 sentence explanation. i. A loan ocer is typically paid based on the volume of loans that he originates (and not their nal performance) whereas a construction manager is only paid upon the successful completion of a project. What reasons would the theory above oer for such dierent incentive contracts? ii. Consider a hierarchy with a CEO on top, the division manager below him 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 profits, plant level prots, plant level costs. What is the main 1

tradeo shareholders face for designing an incentive scheme for the plant manager?