ASSIGNMENT -14

Soubhagya Dash
PGP/25/116
Q10.

Package 1:
the CEO will give low effort to maximize utility:
Low Effort: E(U) = ($575,000).5 = 758.29
High Effort: E(U) = ($575,000).5 - 100 = 658.29.
Package 2:
the CEO will give high effort to maximize utility:
Low Effort:
E(U) = .3(.06x5,000,000).5 + .4(.06x10,000,000).5 + .3(.06x15,000,000).5 = 758.76
High Effort:
E(U) =.3(.06x10,000,000).5 + .4(.06x15,000,000).5 + .3(.06x17,000,000).5 - 100 = 814.835
Package 3:
the CEO will give high effort to maximize utility:
Low Effort:
E(U) = .3(500,000).5 + .4(500,000).5 + .3(500,000).5 = 707.11
High Effort:
E(U) =.3(500,000).5 + .4(500,000).5 + .3(1,500,000).5 - 100 = 762.40

Now calculate the expected firm profits under each plan net of expected compensation:
Package 1:
Low Effort: E(π) = .30x$5m + .40x$10m + .30x$15m - ($.575m) = $9.425million
Package 2:
Low Effort:
E(π) = .30x$5m + .40x$10m + .30x$15m - (.3x$.3m + .4x$.6m + .3x$.9m) = $9.4m
High Effort:
E(π) = .30x$10m + .40x$15m + .30x$17m - (.3x$.6m + $.4x$.9m + .3x$1.02m) = $13.254m
Package 3:
Low Effort:
E(π) = .30x$5m + .40x$10m + .30x$15m - (.3x$.5m + $.4x$.5m + .3x$.5m) = $9.5m
High Effort:
E(π) = .30x$10m + .40x$15m + .30x$17m - (.3x$.5m + $.4x$.5m + .3x$1.5m) = $13.3m
To maximize the expected profits of ASP Industries, you recommend compensation
PACKAGE 3 which uses a flat salary and then a large bonus when the firm does exceptionally
well and makes $17 million. You prefer this package because it maximizes firm expected
profits net of compensation – here at a value of $13.30 million.

Notice that if you just gave a very large bonus when the firm did exceptionally well, CEO risk
aversion would lead him to make low effort -- or more likely work for someone else. The flat
salary offsets the disincentive effects of a risky – but motivating – package. This is the usual
form of executive compensation. Notice too that compensation is tied to firm profitability.

When the worker gives high effort, always check that your profits are higher under high effort
than under low effort. You might be getting high effort, but you are giving away too much so
that you really prefer that the worker be lazy! Well not really, but you a giving away too much
of firm profits to motivate your employees. If you find this to be a problem, then reduce
compensation while keeping high effort until profits from high effort beat profits from low
effort. Then you have a compensation plan that makes some sense.