11. Discuss how to frame a decision problem when the decision-maker is faced with uncertainty?

In a decision-making context, when is information useful/useless?

ANS: We'll start by applying the preceding concepts of consistency and smoothness to a new
structure. This will allow us to characterize choice behaviour as if the utility function's expected
value were being maximized. We next use the framework of this choice model to investigate a
powerful framing device known as certainty equivalents, risk aversion, and the arrival and use of
information in a choice scenario.

To start our discussion, we need to star by defining what is Decision framing and how can affect our
situation. Decision Framing deals with how humans interact and make decisions under certain
situations. When we talk about decision framing, we need to include uncertainty, since it can affect
our final decision in several ways:
- Accounting tries to make up for the fact we don’t have all the information that we need.
- Decision framing is used in the evaluation process of agent’s; this evaluation process is based on
the uncertainty that we have about the agent’s behaviour.
- Risk is always an important factor to consider when we are making decisions.

Now that we have defined decision framing, we must agree that the use and acquisition of
information is a key element in our process, that’s why we should be able to evaluate the usefulness
of information. Information is used to reveal if the signal used by the agent is good (g) or bad (b),
because depending on the signal that we observe we will make different choices.

To understand better the discussion, I am going to use Exercise 9.14 as an example of decision
making when we face uncertainty and how to know if information is useless or not.

Under this exercise we find that Ralph is facing a decision issue where the dollar outcome is
uncertain. Ralph faces 3 possible choices with 4 equally likely states. So, at the end we have 12
possible outcomes.

the end we have 12 possible outcomes.

The probability of each state is 0.25 since they are all equally probable.
- In the absence of any information the best choice is 2, as it is the one with the highest expected
utility

E[w/1] = 225*0.25+225*0.25+225*0.25+100*0.25 =193.75

- If now we suppose that Ralph can purchase information before making the choice, and that the
information will reveal if the actual state is s1 or s2 vs s3 or s4. With additional information, we can:
o Ignore the information
o Exploit the information by varying the underlying choice depending on what the information
reveals.
The decision depends on the outcome structure, the probabilities, and the attitude towards risk.
Under this situation Ralph will opt for 2 if s1 or s2 are revealed and 3 if s3 or s4 are revealed. We
can notice that s4 leads always to 100, but s3 offers 225, 100 or 625.

How much will pay Ralph for the info? Since 2 is the choice, we get that the performance gain is:
0.5*(900) + 0.25(625) + 0.25(100) – 500 = 131.25

By having this info Ralph wins extra 131.25, so buying this information will give higher wealth631.25.
Information gives more quality to the decision-making process
- What happens if now information cost 500? In this situation Ralph would not buy the information
because he only willing to pay 131.25. So, he would return to the first situation and choose 2 as he
will get the most expected benefit here
√

12. Discuss strategic interaction between a seller and a buyer when the seller is better informed
about the value of the object.

Ans: In order to start our discussion, we need to star by saying that Decision Framing deals
with how humans interact and make decisions under certain situations.

CONCEPTOS BASICOS DECISION FRAMING

We can use decision framing in very different situations, but when we talk about equilibrium
behaviour when there are no competitors, we are referring to the subject of haggling. The basic
setup in a haggling situation is the following one:

The seller has a cost:   x

- The value of the project is V, and we assume that V > 
- The net social gain of the project can be:
o No deal = 0
o Deal: V - 
The ways in which the seller and the buyer will split the net gain of the project will depend on how
individuals play the game. In this case I will assume that the seller is better informed about the value
of the object. But is the buyer the one that will make the offer.

NUMERICAL EXAMPLE:
- The cost () is either 1 or 2, with equal probability or probability 0.8 and 0.2 respectively
- The value of the project is 4.
- The net gain can be:
o =1  4 - 1 =3
o =2  4 – 2 = 2
The buyer is the one that is making an offer of P = 2.
- Seller: cannot do better than always accepting the offer:
o Net gain low : P -  = 2 – 1 = 1  accept
o Net gain high : P -  = 2 – 2 = 0  reject
- Buyer: gains V – P = 4 – 2 = 2
Now suppose that P = 1.
- Seller: will accept or reject the offer depending on the cost:
o Net gain low : P -  = 1 – 1 = 0  accept offer
o Net gain high : P -  = 1 – 2 = - 1  reject offer
- Buyer: gains V – P = 4 – 1 = 3
What will the buyer prefer? It will depend on the probability of having a low cost or high cost.
- Equal probability distribution:
o P = 2  0.5(2) + 0.5(2) = 2
o P = 1  0.5(3) + 0.5(0) = 1.5
- Probability 0.8 for low cost and 0.2 for high cost:
o P = 2  0.8(2) + 0.2(2) = 2
o P = 1  0.8(3) + 0.2(0) = 2.4
As we can see the outcome will depend on:
- If the buyer knows the seller’s cost () it will always make the offer so that P
=
- If the buyer doesn’t know the cost, he has two options:
o P = higher cost  trade happens always, and the seller get some surplus
o P = low cost trade only occurs if cost is low, but no surplus is shared.

As a conclusion, we get that the buyer is not able to capture the full gain, despite the advantageous
of its position, and that by having some private information the seller has some advantage over the
buyer

Example - Assignment 6 (short overview - seller has more information than buyer).
Ralph wants to purchase a car, which has value V, and Ralph knows V is uniformly distributed
between v=0 and v=300.000 (FF knows this). The value of the car to Ralph is 1,4V (he really wants
that car – FF knows this).

Ralph should own the car because he values the car highest. It is better for FF to sell the car to Ralph
than to keep it himself (because value for Ralph is higher 1,4V than for FF "only V").

If instead the value to Ralph was equally, then FF would be indifferent whether to keep it or sell it. If
instead the value to Ralph was below V, then FF would not sell it to Ralph, because he would lose.
From an economic perspective, it is best if FF sells the car to Ralph, because both parties would gain.
Expected value of the car is E(v)=0,5*0+0,5*300.000 = 150.000 or E(v)=P/2= (0+300.000)/2=150.000
(before any conversation). Expected value of the car to Ralph is, 1,4*150.000=210.000.

If we suppose Ralph offers P>0 and FF accepts the offer, what is the expected value?
Since FF accepted the offer, we now know that v≤P. By using the uniformly distribution we change V
with P and thereby get: 1,4E[v│v≤P] =1,4*P/2=0,7P Now the value is 0,7P, so Ralph pays 30% more
than the actual value (he pays P for 0,7P). The value to Ralph is now 105.000 if we assume price was
150.000 (because he is willing to pay 210.000). Equilibrium is that both players can’t take a better
decision according to each possible strategy the other player in the game has. In our case, we don’t
have an equilibrium because FF have an advantage over Ralph (FF knows more than Ralph). There
will never be a trade because they can’t agree on a price because FF’s information about Ralph (this
is winner’s curse). Ralph will always pay more than the car is actual worth. FF can always observe
Ralphs choice and make a reaction to this with the information he has about Ralph. Ralph will never
pay P for something he only value 0,7P. Every P FF will accept will not be acceptable for Ralph.

13. Discuss optimal performance evaluation when the manager's action choice is unobservable.
Especially, argue for why the likelihood ratio is important.

Ans: Performance evaluation is the conflict that arises when a firm wants to hire a manager. The firm
has an interest in evaluating the manager’s performance when the firm can't observe the inputs
(probabilities). The firm's purpose is to make the manager work hard, so the manager always provide
highest effort, thereby the firm will pay the manager more if this is accomplished, because the
manager can tend to only provide low effort (because it is easier for him than high effort).
The basics:
The basic setting in performance evaluation is that the owner (principal) of a firm wants to hire a
manager, and the manager can provide high or low effort to the firm (𝑎𝐻, 𝑎𝐿). High effort is always
preferable for the firm (𝑎𝐻 > 𝑎𝐿). The probability of output is uncertain/unobserved (𝑥1, 𝑥2) by the
firm, the manager can provide output (𝑥1, 𝑥2)) supplied by high or low effort. The principal (owner
of the firm) is risk neutral (indifferent to risk “only thinks about profit and not risk”).

Expected value to the firm when the manager provides high effort, 𝐸(𝑉|𝑎𝐻) = (1 − 𝛼)𝑥1 + 𝛼𝑥2 −
𝐶(𝐻), or when the manager provides low effort, 𝐸(𝑉|𝑎𝐿) = 𝑥1 − 𝐶(𝐿) (where 𝑥1 = 𝑜𝑢𝑡𝑝𝑢𝑡, 𝛼 =
𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦, 𝐶(𝐻) = 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑚𝑎𝑛𝑎𝑔𝑒𝑟 𝑐𝑜𝑠𝑡 , 𝑎𝑛𝑑 𝐶(𝐻) = 𝐸(𝐼|𝑎𝐻)). We know that the expected
value of the firm is greater when the manager provides high than low effort (𝐸(𝑉|𝑎𝐻)> 𝐸(𝑉|𝑎𝐿)),
therefore the principal would always want the manager to provide high effort. The firm will pay the
manager bonus/salary denoted C(H), which the firm want to minimize, but in a setting where the
manager provides high effort. The manager is risk averse (focuses on risk “prefer lower profit for less
risk than high profit for high risk”). His utility is 𝑈(𝐼, 𝑎) = 𝑈(𝐼𝑖 − 𝑐𝑎 ) = −exp (−𝜌(𝐼𝑖 − 𝑐𝑎)) (utility
function for constant risk aversion), where "I" is the payment from the principal to the manager,
which depends on the realized output, and 𝜌 is the managers risk aversion parameter. The manager
has personal cost of providing high or low effort 𝑐𝐻 and 𝑐𝐿 (cost if supplying 𝛼 = 𝑎𝐻), which is the
managers preferred salary to cover his costs, we always assume 𝑐𝐻 > 𝑐𝐿 (goal in-congruence). In
addition, the manager has opportunity cost of "M", this is his alternative of working somewhere ells.
The utility of opportunity cost is 𝑈(𝑀) = −exp (−𝜌(𝑀)).

This setup can be shown in a decision tree.

The manager have three main option choices, which are work for another company, or work for our
firm providing either high effort or low effort. The output can either yield high or low return.

The firm always want to manager to stay for the firm and then to provide high effort. Therefore, we
have two constraint IR (to make manager work for us) and IC (to make manager work hard).

The solution:
The solution to this is to find the minimum payment to the manager where he provides high effort. If
the principal can observe what the manager is supplying (effort choice) of output and input, then he
simply determine the expected payment to the manager as his personal cost of high effort added up
with opportunity cost, 𝐼(𝑎) = 𝐸(𝐼) = 𝑐𝐻 + 𝑀 (if high effort otherwise 0 if low effort) (we don’t need to
minimize the problem, because we observe what the manager does). Instead, if the principal cannot
observe the managers effort choice (only observe output but not input), then the principal can’t
motivate the manager with a fixed payment, therefore we need to create a pay-forperformance
bonus contract that gives the manager an incentive to provide high effort. The payment is a function
of output (x), which determines the optimal payment for all possible outputs:
𝐼(𝑥) = 𝐼1 𝑖𝑓𝑥 = 𝑥1 𝐼2 𝑖𝑓 𝑥 = 𝑥2
The overall goal for the firm is to minimize the cost/payment to the manager, but still to give the
manager an incentive to work hard. If there is a need to construct a pay-for-performance contract,
then expected payment when providing high effort to the manager for all potential outputs is
minimized, 𝐶(𝐻) = min (𝐸(𝐼|𝑎𝐻) = (1 − 𝛼)𝐼1 + 𝛼𝐼2).
This problem is subject to two constraints IC and IR, where IC is the manager's incentive to provide
high effort, and IR is the incentive to keep the manager working for the firm instead of taking his
alternative.

𝐼𝐶: 𝐸(𝑈|𝑎𝐻, 𝐼𝑖 ) ≥ 𝐸(𝑈|𝑎𝐿, 𝐼𝑖) (expected utility providing high effort is greater than for low effort) 𝐼𝑅
= 𝐸(𝑈|𝑎𝐻, 𝐼𝑖 ) ≥ 𝑈(𝑀) (expected utility providing high effort is greater than utility of opportunity
cost) Where the expected utility when the manager is providing high or low effort is:
𝐸[𝑈|𝑎 = 𝑎𝐻, 𝐼(𝑥)] = 𝛼 ∗ − exp(−𝜌(𝐼2 − 𝑐𝐻)) + (1 − 𝛼) ∗ − exp(−𝜌(𝐼1 − 𝑐𝐻)) (high effort)
𝐸[𝑈|𝑎 = 𝑎𝐿, 𝐼(𝑥)] = 1 ∗ (−𝜌(𝐼1 − 𝑐𝐿)) (low effort)
This makes the principal offer the contract that makes the manager work hard and to stay in the
firm. Above is the so-called pay-for-performance contract. IR and IC are binding otherwise it will
lower payments:
* If IR is not binding then it will lower payments (lowering both I1 and I2)
* If IC is not binding then incentives are too strong (higher I1 and lower I2 - more flat schedule)
The extra amount paid to the manager, when the principal does not know whether the manager is
working hard or lazy, is called risk premium, 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐸(𝐼|𝑎𝐻) − 𝑐𝐻 − 𝑀. The principal
always pay an extra amount to the manager (if he does not know if he is working hard/lazy), unless
LRx1=LRx2 (likelihood ratio), then the risk-premium would be 0. Certain Equivalence (CE) is a
guaranteed return that the manager would accept rather than taking a change on a higher, but
uncertain, return. Certainty equivalent is the extra amount of cash the manager would have less his
personal costs. It is the guaranteed amount of cash, that would yield the exact same expected utility
as a given risky return with absolute certainty, and represents the opportunity cost of risk in this
setting. If 𝐶𝐸𝐿 < 𝐶𝐸𝐻 then the managers best option is to provide high effort. CE is calculated from
expected utility: 𝐶𝐸𝑖 = −𝐿𝑁(−𝐸(𝑈(𝐼|𝑎𝑖))/𝜌

Argue for why the Likelihood Ratio is important.

Likelihood ratios:
The principal in the firm can evaluate that pay-for-performance contract by looking at the likelihood
ratio (𝐿𝑅𝑦,𝑥 = 𝜋(𝑦, 𝑥|𝐿) 𝜋(𝑦, 𝑥|𝐻) , which measures the performance of the manager.
Controllability: We can use the likelihood ratios to determine whether the output is controllable or
not. Likelihood ratios are measured as 𝐿𝑅𝑥1 = 𝜋(𝑥1|𝑎𝐿) 𝜋(𝑥1|𝑎𝐻) and 𝐿𝑅𝑥2 = 𝜋(𝑥2|𝑎𝐿) 𝜋(𝑥2|𝑎𝐻) If
𝐿𝑅𝑥1 = 𝐿𝑅𝑥2 then the output is not controllable (output x1 and x2 is the exact same), there are no
way to use the output in order to make the manager work hard (no way to pay-for-performance).
The output is controllable if 𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2, then there is a pay-for-performance contract (output can
be used to pay bonus), which indicate the manager can affect his outcome most (pay most when LR
is least, and pay least where LR is the highest amount). There is only pay-for-performance if LR is
different for the outputs, if not then no pay-for-performance. Inverse relationship between
likelihood ratio (LR) and payments (I). Pay most when LR is lowest: If 𝐿𝑅𝑥3 = 𝐿𝑅𝑥4 < 𝐿𝑅𝑥1 < 𝐿𝑅𝑥2
then 𝐼𝑥3 = 𝐼𝑥4 > 𝐼𝑥1 > 𝐼𝑥2 . Interpret LR ratio: If LR for x1 is 5,22, then it means that there is 5,22
times higher probability that the manager has supplied low effort instead of high effort.

Summary: Overview
Setup (Basics).
 The owner of a firm (the principal) hires a manager (the firm prefer the manager to provide H).
 The manager can either provide high or low effort (𝑎𝐻 > 𝑎𝐿) (output is uncertain (𝑥1, 𝑥2)).
 The principal (owner of the firm) is risk neutral (indifferent to risk).
Expected value to firm for high effort 𝐸(𝑉|𝑎𝐻) = (1 − 𝛼) 𝑥1 + 𝛼𝑥2 − 𝐶(𝐻), and for low effort 𝐸(𝑉|𝑎𝐿)
= 𝑥1 − 𝐶(𝐿) (where 𝐸(𝑉|𝑎𝐻) > 𝐸(𝑉|𝑎𝐿)).
 Idea is to find the minimum payment to the manager (C(H)) from the expected value.
 The manager is risk averse (focuses on risk) Manager’s utility is 𝑈 (𝐼, 𝑎) = 𝑈 (𝐼𝑖 − 𝑐𝑎) = −exp (−𝜌 (𝐼𝑖 −
𝑐𝑎)) (constant risk aversion, where 𝜌=manager’s risk aversion parameter, I=payment to manager,
ca=manager’s personal cost).
The manager has personal cost of cH and cL, and opportunity cost of M (salary for another firm).

Solution (Key insights).

 If principal can observe the manager for either high or low effort. Expected cost (payment) is then
𝐸(𝐼) = 𝑐𝐻 + 𝑀 (otherwise 0 - No need for minimize).
 If principal cannot observe the manager for either high or low effort (only observe output not
input). Then a pay-for-performance bonus contract is now required (determine “I” for all possible
outputs).
 Pay-for-performance bonus contract is the minimization of providing high effort to manager for all
outputs, 𝐶(𝐻) = min (𝐸(𝐼|𝑎𝐻) = (1 − 𝛼) 𝐼1 + 𝛼𝐼2). Subject to 𝐼𝐶: 𝐸 (𝑈|𝑎𝐻, 𝐼𝑖) ≥ 𝐸 (𝑈|𝑎𝐿, 𝐼𝑖) (make
sure manager is working hard) and 𝐼𝑅 = 𝐸 (𝑈|𝑎𝐻, 𝐼𝑖) ≥ 𝑈(𝑀) (make sure manager is not taking
alternative job "opportunity cost").
 Extra amount from observable to not observable is risk premium, 𝑅𝑃 = 𝐸(𝐼|𝑎𝐻) − 𝑐𝐻 − 𝑀.
 Certainty equivalent: Extra amount of cash the manager would have less his personal costs.

Likelihood ratios and additional information.

 Principals evaluate the pay-for-performance contract by measure performance of manager by LR
 Controllability: Measured by likelihood ratio to determine if output is controllable or not
controllable.
If 𝐿𝑅𝑥1 = 𝐿𝑅𝑥2 (output is not controllable “no way to use output for contracting” – no need for pay-
for performance), otherwise, 𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2 (output is controllable “use output for contracting” –
pay-for performance contract). (Pay most when LR is least and pay least where LR is the highest
amount).
(𝐿𝑅𝑦,𝑥 = 𝜋(𝑦, 𝑥|𝐿) 𝜋(𝑦, 𝑥|𝐻)

14. Discuss optimal performance evaluation when the manager's action choice is unobservable.
Especially, is the most desirable outcome always rewarded with the highest payment?

Is the most desirable outcome always rewarded with the highest payment.
If we setup a pay-for-performance minimization of the firm’s cost to the manager and have the two
necessary constraint (IR and IC), then the most desirable outcome is sometimes the highest
payment, because the expected value (payment to manager) of providing high effort is larger than if
he provides low effort. However, it is not always like that, because LR determine if we should pay a
high payment, so even if output is high and LR for x1 is higher than for x2, then we would pay most
for x2 and not for x1. The idea is that the manager is paid more when he behaves, and he is paid less
if he misbehaves or work for another company. We assume the manager is risk averse, which means
he would always prefer higher salary for less risk.

15. Discuss optimal performance evaluation when the manager has three unobservable action
choices. Provide intuition for when each of the three possible choices is optimal for the principal.

Ans: When we talk about performance evaluation, we refer to the natural conflict that arises when a
firm wants to acquire managerial inputs in an imperfect market setting. When the input cannot be
observed the firm has an interest in evaluating the performance of the manager, so the firm can
assess the action choices of the manager. But if manager’s actions are unobservable, how can we
evaluate the performance of the manager? In order to answer this question, I am going to use
Exercise 13.13 of the book. Under this exercise we find that Ralph (the owner of the company) has a
production process that requires input from a manager. The manager can supply three different
possibilities of input (L < B < H), output can be two possible quantities x1 < x2. The output
probabilities are as follow:

If we suppose that Ralph only knows the output and that input remains unobservable. We can see
that the manager can chose among three different inputs to produce output x2 (the preferred one).
Ralph should design a contract they will ensure the supply of input H, B, or L
- Input H: in this case Ralph creates incentives for the manager to deliver x2.
For x2 Ralph will pay the manager cH + M = 10000 + 40000 = 50,000
I1 = 0 I2 = 50,000

If the manager gives H, it will give 100% of x2, because if we find x1 the manager will be penalized.
Since there is no risk for outcome x1 and since x2 is the preferred alternative there will be no risk
premium to be paid.
- Input B: in this situation Ralph is concerned that the manager will be tempted by input L. Ralph is
sure that if he pays 50,000 the manager will give H, but this is too expensive, so he would rather
have that the manager gives B (where there is a 90% chance that x2 is the result). The manager must
be compensated for this risk Ralph will need to make a contract that will pay the manager is
correspondence with what output is found. Ralph should create some incentives for the manager
but not strong, since there is the possibility of the manager choosing input L.

I1 = 39,596.17 I2 = 44,634.45 In this situation, the owner of the company is concerned that the
manager may be tempted by input L instead of B. We can see that the manager is compensated by
the risk that it has. - Input L: under this situation the manager will work for the company has he
provides low input. The company doesn’t need to create incentives
I1 = I2 = cL = 40,000
So, at the end, we get that Ralph will design a contract that will fit best his objectives for the
company to make the manager work for a determined input.

16. Discuss additional information in the optimal performance evaluation setting. Especially, when
is additional information of value?

Ans: When we talk about performance evaluation, we refer to the natural conflict that arises when a
firm wants to acquire managerial inputs in an imperfect market setting. When the input cannot be
observed the firm has an interest in evaluating the performance of the manager, so the firm can
assess the action choices of the manager. If we start with the basic setting in which the manager can
provide input L or H, being H the more attractive input (the company wants the manager to supply
input H), we also assume that the manager is risk averse and that the company can only observe the
final output (x1 or x2, being x1< x2) provided by the manager and not input H or L, since the
manager can choose between working hard (H) or not (L), it will be tempted to work less and
provide the manager with input L instead of H.
That’s why the owner of the company must provide the manager with a Pay-for- Performance
contract that will make interesting enough for the manager to work for the company and work hard
and provide input H instead of L.
C(H)=min. E [ I|H] = (1−α) I 1+α∗I 2
st: E (U|I 1, I 2, a=H) ≥E (U|I 1, I 2, a=L)
E (U|I 1, I 2, a=H) ≥E (U (M))
The main reason why the owner of the company needs to provide a Pay-for- Performance contract is
that he cannot observe what the manager is doing (working hard (H), or not (L)). This means that
output is an imperfect signal in relation to the manager’s input.
If we want to know the effect that additional information may have on the Optimal Performance
Evaluation, we may need to change a few things form our original setting. Now we assume that
instead of contracting simply on output (x), we have a second publicly observed variable (y) that can
also be contracted on. This additional variable is observed at the same time as the output. Now the
contract will depend on both x and y. Ixy will denote the manager’s compensation when output x
and performance measure y are observed. Now we have the following minimization problem:

Under this new optimization program, we have two possible solutions:

- Ignore the new measure of information. This can be done if variable y is independent of the
manager’s compensation (Ixy). This will lead us again to the solution in our initial setting.
- Useful new information: under this case manager’s compensation is dependent of the new variable
y. This will lower firm’s cost from C(H) to C(^H), this new variable is able to lower the contracting
friction, as this new arrangement lower the risk premium for the manager.
INTRODUCE NUMERICAL EXAMPLE 14.3
If we want to go into a deeper detail, we can use the measure of the Likelihood ratio to explain why
the information is useful and how it is best used. Our model uses the information by varying the
manager’s compensation I*
xy as a function of LRy∨x= π (y∨x, L) π (y∨x, H)
. If we now introduce two more setting, we have the following table:

We can see from these three tables that the optimal incentive contract I *xy varies with LRxy. The
relationship is inverse a lower ratio means a higher compensation (a lower ratio means that the
combination (x, y) is less likely if the manager misbehaves (L) than if the manager behaves (H). At the
end, we can conclude that performance measure y is informative in the presence of output x if the
conditional likelihood ratio LRxy varies with y for at least one realization of output x.

Added to this question.

We use LR to see if the output is informative and controllable. We compare RP for additional
information with no additional information, and then see whether RP for additional information is
less, which means the information is useful can valuable.

17. Define and contrast the concepts “controllable performance indicator” _and “conditionally
controllable performance indicator”.

Ans: The principal in the firm can evaluate that pay-for-performance contract by looking at the
likelihood ratio (𝐿𝑅𝑦, 𝑥 = 𝜋 (𝑦, 𝑥|𝐿) /𝜋 (𝑦, 𝑥|𝐻), which measures the performance of the manager.
In here, we look at the two performance measurements, which is Controllable Performance
Indicator and Conditionally Controllable Performance Indicator.

Controllable Performance Indicator.

A performance indicator is controllable if manager can influence the outcome of supply high or low
effort. If the variables outcome is unaffected by the manager's behaviour (𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2), then the
manager does not control the variable. The intuition behind this is that a manager should be
evaluated based on the measure he can control (those he can influence or affect through his
actions). For example: If a manager gets a rush order from marketing department, then he is obliged
to manage that order, so he has no control over this (he should not be held responsible for this
order).

Controllability: We can use the likelihood ratios to determine whether the output is controllable or
not. Likelihood ratios are measured as 𝐿𝑅𝑥1 = 𝜋(𝑥1|𝑎𝐿) /𝜋(𝑥1|𝑎𝐻) and 𝐿𝑅𝑥2 = 𝜋(𝑥2|𝑎𝐿) /𝜋(𝑥2|𝑎𝐻)
If 𝐿𝑅𝑥1 = 𝐿𝑅𝑥2 then the output is not controllable (output x1 and x2 is the exact same), there are no
way to use output to make the manager work hard (no way to pay-for-performance). The output is
controllable if 𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2, then there is a pay-for-performance contract (output used to pay
bonus), which indicate the manager can affect his outcome most (pay most when LR is lowest and
pay least when LR is high). There is only pay-for-performance if LR is different for the outputs, if not
then no pay-for-performance.

Conditionally Controllable Performance Indicator.

A performance indicator is conditionally controllable if the manager can influence the outcome of
supplying high or low effort, given whatever other information is available. We use conditional LR
when we have an additional information, so instead of only contracting on output "x" we can now
also contract the additional information "y". That's why we can see whether this information is
useful or useless. When we have additional information we extend the model by the output, so we
now define x1 for either good or bad (the same for x2). This additional information denoted “y” is
the “good/bad” state in output x. Again, we look at the risk premium (it is getting higher or lower),
which indicate if this information is useful. We add another performance measure (conditional
likelihood ratio) where the additional information “y” is informative for contracting if it varies 𝐿𝑅𝑥1𝐺
≠ LRx1B (otherwise, 𝐿𝑅𝑥1𝐺 = LRx1B then it is not informative), which means it is useful (informative)
for contracting to lower risk premium and for predicting outcome (for example revenue). Conditional
likelihood ratio, 𝐿𝑅𝑦|𝑥 = 𝜋 (𝑦|𝑥, 𝐿)/𝜋 (𝑦|𝑥, 𝐻) = 𝑥1𝐺, 𝐿
𝑥1𝐺, 𝐿+𝑥1𝐵, 𝐿/ 𝑥1𝐺, 𝐻 𝑥1𝐺, 𝐻+𝑥1𝐵, 𝐻.
To evaluate the controllability on the additional likelihood we use the unconditional likelihood ratio.
From here, we say that the performance measure "y" is controllable if the unconditional likelihood
ratio 𝐿𝑅𝑦 varies with "y". If an additional measure "y" is to be useful, it must be informative. Its
conditional likelihood ratio must somewhere vary with “y”, otherwise it carries no new information
to the performance evaluation. Therefore, the unconditional likelihood ratio is the ratio between
good state for low effort and hard effort, 𝐿𝑅𝑦|𝑔 = 𝐿𝑅𝑦|𝑏 ∶ 𝜋 (𝑥|𝑔, 𝐿)
𝜋(𝑥|𝑔, 𝐻) ≠ 𝜋(𝑥|𝑏, 𝐿) 𝜋(𝑥|𝑏, 𝐻) . If it varies then it is controllable for decision-making (the decision
on what to pay the manager in bonus).

Summary of Controllability and Conditionally:

Conditional likelihood ratio: INFORMATIVE
(if they vary the additional information "y" is useful, otherwise it has no value)
Unconditional likelihood ratio: CONTROLABLE
(if they vary the additional information "y" is useful in evaluating his performance
If unconditional LR vary, then conditional LR is useful.

When is an additional performance indicator of value in a Performance Evaluation setting?

We use LR and RP when additional information is present to see if the information is useful or
useless.
The relationship is inverse; therefore, a low ratio means higher compensation (the combination of
"x, y" is less likely that the manager misbehaves "L" than behaves "H"). In the end, we can conclude
that the performance measure "y" is informative if the likelihood ratios vary from x to y.

Summary:
 If principal can observe the manager for either high or low effort. Expected cost (payment) is
then 𝐸(𝐼) = 𝑐𝐻 + 𝑀 (otherwise 0 - No need for minimize).
 If principal cannot observe the manager for either high or low effort (only observe output
not input). Then a pay-for-performance bonus contract is now required (determine “I” for all
possible outputs).
 Pay-for-performance bonus contract is the minimization of providing high effort to manager
for all outputs, 𝐶(𝐻) = min (𝐸(𝐼|𝑎𝐻) = (1 − 𝛼) 𝐼1 + 𝛼𝐼2). Subject to 𝐼𝐶: 𝐸 (𝑈|𝑎𝐻, 𝐼𝑖) ≥ 𝐸 (𝑈|
𝑎𝐿, 𝐼𝑖 ) (make sure manager is working hard) and 𝐼𝑅 = 𝐸(𝑈|𝑎𝐻, 𝐼𝑖 ) ≥ 𝑈(𝑀) (make sure
manager is not taking alternative job "opportunity cost").
 Extra amount from observable to not observable is risk premium, 𝑅𝑃 = 𝐸(𝐼|𝑎𝐻) − 𝑐𝐻 − 𝑀.

Controllable Performance Indicator:

 Principal evaluate the pay-for-performance contract by measure performance of manager by
LR
  Controllability: Measured by likelihood ratio to determine if output is controllable or not
controllable. Manager should be evaluated on the PM he can control (Manager can
influence outcome x through H or L if 𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2. Manager can’t influence outcome x if
𝐿𝑅𝑥1 = 𝐿𝑅𝑥2): If 𝐿𝑅𝑥1 = 𝐿𝑅𝑥2 (output is not controllable “no way to use output for
contracting” – no need for pay-for performance), otherwise, 𝐿𝑅𝑥1 ≠ 𝐿𝑅𝑥2 (output is
controllable “use output for contracting” – pay-for performance contract). (Pay most when
LR is least and pay least where LR is the highest amount).
(𝐿𝑅𝑦,𝑥 = 𝜋(𝑦, 𝑥|𝐿) /𝜋(𝑦, 𝑥|𝐻)
Conditionally Controllable Performance Indicator:
 Model is extended with good and bad outcome for output x1 and x2.
 Again, look at RP (compare RP)
 Constraints changes a little (IR: Expected utility for high effort must be greater than -1)
 If LRx varies there is still controllability (same)
 Conditional likelihood: Additional information “y” is informative for contracting if 𝐿𝑅𝑥1𝐺 ≠
LRx1B (meaning useful “informative” for contracting to lower RP and to predict outcome
“revenue”) (otherwise not informative)
 Unconditional likelihood: Additional information “y” is informative for decision-making (the
decision on what to pay the manager in bonus) if they vary 𝐿𝑅𝑦|𝑔 = 𝐿𝑅𝑦|𝑏 ∶ 𝜋 (𝑥|𝑔, 𝐿) 𝜋
(𝑥|𝑔, 𝐻) ≠ 𝜋 (𝑥|𝑏, 𝐿) 𝜋(𝑥|𝑏, 𝐻)
 Use LR and RP in additional information to if the information is useful or useless. Low ratio
means higher compensation (because combination of “x, y” is less likely that he provides L
than H).

18. Discuss tables 14.1, 14.2, 14.3, 14.4 and 14.5.

We have additional information "y" for the output "x". If we observe x2, then the firm is sure that
the manager will perform H, because there is 0% probability of behaving L, which is also the reason
why the "I's" become the exact same (because probability for L is 0). The information is useful
because the cost with additional information is lower than without information (𝐶 ̂ (𝐻) < 𝐶(𝐻)), this
means it gives way more correct answer with information than without this information (same for
RP, this is also lower). We use likelihood ratio as another source of measuring the manager’s
performance. LR is exactly 0 in both cases for x2, then the payment becomes the same (because
probability L is 0). LR differs in x1, then output is controllable (we use output to make the contract:
pay most when LR is least and pay least where LR is the highest amount “pay most for x1g because
lowest LR”) Conclusion is that information is only controllable for x1 and not x2 (only use output to
contract on for x1). If we add conditional LR, we observe the additional information is not
informative for 𝑥2 (𝐿𝑅𝑥2𝑔 = 𝐿𝑅𝑥2𝑏). It is informative for 𝑥1, because LR vary (2,28<2,66), which
means “y” is useful (informative) for contracting to lower risk premium and for predicting outcome.

In this case the additional information is useless because the cost (C(H)) is the exact same ( 𝐶 ̂ (𝐻) =
𝐶(𝐻)).
Again, we have a situation where probability of L is 0% in both cases for x2, which indicate that only
H is performed (high effort), and this gives the exact same payment of "I" for x2.
In x1 the probabilities vary of H and L, therefore we will use LR, which is the same in both cases for
x1, then output is not controllable (we can’t use this output to contract on – we can’t make manager
work hard) (no way to pay-for-performance).
Because LR is exactly 0 in both states for x2, then the payment contract becomes the same (we can’t
use output to contract on).
We can conclude the additional information did not make the contract better (information is
useless).
The conditional LR is equal in both cases, so by that we can say that the information is not
informative.
Therefore, we can’t use this information to contract on.
First, we observe that the cost is less with additional information than without this information,
which
makes the information useful. The information gives a better overview of the payment than without
this information even though the probability of H is the exact same for "g and b" (which should
indicate the information is useless, but it is not because C(H) is lower).
If we look deeper into this, we see the LR combined for x1 (60/40) is greater than for x2 (40/60), this
indicate that the payment has to be larger for x2 (highest payment where LR is lowest). If we split LR
out on the additional information, we see that they all vary, which also means the information is
useful (output are controllable in all cases) (additional information are only useful if LR varies). We
will pay most where LR is lowest (𝑥2𝑔), and we pay least where LR is highest (𝑥1𝑏). We can conclude
that this additional information is useful because C(H)<C(H), and then RP is also less for additional
information.
However, this information is only useful for x1 and not x2, because LR vary in x1 but are equal and 0
in x2. We will still pay the highest payment when LR is lowest, which it is for x2.
If we look at the conditional LR we can also see that both 𝑥1 and 𝑥2 varies with “y”, so the
information is informative in both cases, which means “y” is useful (informative) for contracting to
lower risk premium and for predicting outcome. Unconditional LR tell us that output is controllable
where we prefer 𝑥1.
For table 14.1 and 14.2, we see that x1 has a higher probability of L (1) than H (0,5), therefore the
payment becomes I=0 (or negative if L is higher than H but lower than 100%) (because probability of
x1(L) are higher than x1(H), then we don’t want to contract on this).
LR vary therefore output is controllable. We pay most for x2 (LR is lowest) and least for x1 (LR is
highest).
For table 14.3, we see that probability of L (0,60) is larger than H (0,40), which indicate that we will
pay a negative payment for this.
Therefore, LR is larger for x1 (so we pay least), and LR is lowest for x2 (we pay most for x2). The
information is useful if LR vary, which is does (output is controllable, so we can use it to contract on).
Table 14.1: Conditional LR varies with signal y for x1 (informative), but no variation for x2 (not
informative). This means the information is only useful (informative) for x1 and not for x2.
Table 14.2: Conditional LR is equal, which means the information is useless in both cases (not
informative).
Table 14.3: Conditional LR varies in both, therefore the information is useful (informative, which
means output can be used to lower RP, and it is useful to predict outcome ”revenue/profit”). Above
we just showed that an additional performance measure simply cannot be useful in evaluation the
manager’s behavior unless it brings new information to the table. Bringing new information to the
table means we have the potential to learn something new about the managers behavior.

Summary:
 Program to minimize cost:
𝐶(𝐻) = min (𝐸(𝐼|𝑎𝐻) = 𝐼𝑥𝑦𝜋(𝑥, 𝑦|𝐻).
𝐼𝐶: 𝑐̅Σ 𝑈(𝐼𝑥 )𝜋(𝑥|𝑎𝐻) ≥ Σ 𝑈(𝐼𝑥 )𝜋(𝑥|𝑎𝐿) (expected utility for high effort has to be greater
than U for low)
𝐼𝑅: 𝑐̅Σ 𝑈(𝐼𝑥 )𝜋(𝑥|𝑎𝐻) ≥ −1 (expected utility for high effort has to be greater than -1) Where
𝑈(𝐼, 𝑎) = 𝑈(𝐼𝑖 − 𝑐𝑎) = −exp (−𝜌(𝐼𝑖 − 𝑐𝑎))
 Likelihood ratio basics:
Controllability: output is controllable if LR vary (output can be used to contract on)
Conditional LR: Information is information (useful) if conditional LR vary (use to lower RP and
to predict outcome “revenue/profit”)
Unconditional LR: Information is informative (useful) if unconditional LR vary (informative for
decision making: decision on what to pay to manager)
 Tables: output can be either x1 or x2 with additional information "y" of "good or bad".
 Table 14.1: Information is useful because C(H) is lower with additional information than
without. Manager will only perform H in x2 (because L=0% and then payment "I" is the exact
same). LR is used to measuring manager's performance:
- LR is 0 for x2, then output is not controllable (payment is exactly the same)
- LR vary for x1 (output is controllable: we use output to contract on) Pay most where LR is least
(x1g), and pay least where LR is highest (x1b).
Conclusion: Information is useful for x1 not for x2.
 Table 14.2: Information is useless because the cost is same (C(H)=C(H)).
Manager will only perform H in x2 (because L=0% and then payment "I" is the exact same).
- LR is 0 for x2, then output is not controllable (payment is exactly the same)
- LR are equal for x1 (output is not controllable) (can't use output to contract on and to make
manager
work hard) (no way to pay-for-performance)
conclusion: Information is useless (not controllable)
 Table 14.3: Information is useful because C(H) is lower with additional information than without.
- LR combined for x1 is greater than for x2 (lowest payment for x1)
- LR all vary (information is useful because output is controllable)
Pay most where LR is lowest (x2g) and pay least when LR is highest (x1b).
 Table 14.4: L for x1 has higher prob (1) than H (0,5) (this makes payment I=0)
- LR vary (output is controllable: pay most when LR is lowest "x2")
L for x1 has higher prob (0,60) than H (0,40) (this makes negative payments)
- LR vary (output is controllable: pay most when LR is lowest "x1")
 Table 14.5:
14.1 = Conditional LR varies for x1 (informative), but not for x2 (not informative)
14.2 = Conditional LR is equal (information is useless "not informative")
14.3 = Conditional LR varies (information is informative)
(output used to lower RP and to predict outcome "revenue/profit")

19. Discuss task allocation. When is it especially costly to incentivize a balanced task allocation?

Ans:
21. Discuss the performance evaluation setting where the manager privately observes additional
information before choosing the effort level.

Ans: A firm always seek to find the right solution of factors that minimizes cost and maximizes profit.
One main task of a manager consists of communicating the private information he observes to the
firm of either high or low effort.
This is due to the fact the manager can have privately observed information (obtained inside the
firm). For the firm to pay the right bonus/payment to the firm requires that the manager reports the
correct information to the firm, so the firm must rely on this (but it might not be the case). We now
add private information and a communication task to our optimal payment solution.

A manager that has private information knows that he is being paid to supply high effort, so his
payment might be lower if he performed low effort, and therefore he has an incentive to
communicate high effort even though he is providing low effort, so he gets a higher payment.

The payment contract with the manager must then be in such a way that the manager is motivated
to provide the correct information at the time. The manager can also manipulate the likelihood
ratios, so he reports the information that makes not controllable for output, then we is not being
paid on that even though he would be controllable for that.

We assume the manager privately observes the signal (y=g or y=b) after supplying input (H or L), but
still before the output (x1 or x2) is observed.
The manager is supposed to report this observation by sending a message that y^=g^ or y^=b^ was
observed. The manager’s compensation will now depend on the self-reported measure and the
observed output (we denote this I_xy^).

The difficulty is when the firm asks the manager to report his private observation, because the
manager know how the reported information will be used to evaluate him. If the information is
publicly known, there is no concern, because everyone knows the correct information, but we have
a problem when the information is privately observed by the manager.

The manager has 4 strategies he can use when he is communicating his information, which gives a
total number of 8 different strategies, because he can report this as either high or low effort.
* Always report “good” (𝑦̂ = 𝑔̂) no matter what have been observed. (g no matter what) (𝑔^ = 𝑔^)
* Always report “bad” (𝑦̂ =𝑏 ̂) no matter what have been observed. (b no matter what) (𝑏^ = 𝑏^)
* Always tell what has been observed. (tell the truth) (𝑔^ = 𝑏^)
* Always tell the opposite of what has been observed. (tell the opposite) (𝑏^ = 𝑔^) (report truth,
stock on g^, stock on b^, opposite)

π(x,y^H,(g^b^)) is the probability of observing output x and self-report y^, given the manager
supplies input H and pursues communication strategy (g^b^). The firm seeks to minimize cost when
the manager supplies H and always report the correct information. Therefore, the solution is to
minimize cost where for input H (g^b^), which are subject to IR and IC. IR is when expected utility for
input (H, g^b^) is greater than -1 (utility of opportunity cost). IC is when expected utility for input (H,
g^b^) is greater than for all other possible strategies, which means we give an incentive for the
manager to always report the correct solution.

IR is the usual constraint where the firm give the manager an incentive to work for us instead of
taking his best alternative somewhere ells.
IC is the constraint that motivates the manager to always tell the truth, so that the desired behavior
when telling the truth is greater than the other strategies.

4. Explain activity-based costing (ABC). Discuss the benefits and costs of ABC and
compare/contrast ABC with traditional costing.

Ans: activity-based costing can be viewed as a rebellion against traditional approaches to costing art,
aimed at improving the estimation of product costs. Activity Based Costing (ABC): Firm = P activities
Activities are tasks that a firm undertakes to make or deliver a product or service. Different resource
costs are driven by different activities like More cost pools (less aggregation), more cost drivers. ABC
is a 2-stage cost allocation system
Stage I: Resource expenditures are allocated to activities: Construct activity cost pools
Stage II: Costs associated with each activity cost pool are allocated to products
 A long run average cost that is useful for decisions with longer term implications.
 Involves tracing overheads.
  Long term variable costs are fixed in the shorter term and vary in the longer term with the
diversity or complexity of activities, not volume.
 Activities and cost hierarchy
 Unit level activities and costs, e.g., Quality control and unit inspection costs
 Product sustaining activities and costs
 Facility sustaining and costs
 Batch level activities and costs.

Merits of ABC
 Improve understanding of activities and costs.
 Identify nonvalue adding activities (not able to convince the customers)
 Moreover, head costs can be traced to products (e.g., receive fee so customers cannot pay
for the products)
 Provide insights to managers assisting them on planning, control and decision making.

Limitations of ABC
 Difficult to maintain and implement.
 Some arbitrary cost apportionments may still be required when using an ABC system.
 Introducing more new products with low volume are likely to be discouraged because of the
higher cost resulted from the increased diversity.

Main Differences Between Activity Based Costing and Traditional Costing

1. Activity-based costing is used to cover only the product cost. On the other hand, traditional
costing is used to cover both the product and the period costs.
2. Activity-based costing is very difficult to learn and understand, and at the same time, the
implementation process becomes very difficult, while traditional costing is easy to
understand, and the implementation process is simple.
3. Activity-based costing is used in external finance, while traditional costing is used in external
reporting statements.
4. Activity-based costing uses multiple drivers for its operational requirements, while
traditional costing uses an identical cost driver for its operational requirements.
5. Activity-based costing uses only two activities, but traditional costing uses four activities.

Differences between activity based costing and traditional costing:

The main points of difference between activity based costing and traditional costing are given
below:
1. Primary Focus:
The primary focus of traditional costing is the apportionment of overhead costs to the activities of
production. Irrespective of the specific allocation of resources, traditional costing sets a single metric
for every activity involved in production and allocates costs based on the consumption of that
metric. Although, activity based costing is also used for cost allocation but it adopts a different
approach. Under activity based costing, appropriate cost drivers are determined for every different
activity and cost is then allocated according to these cost drivers.

2. Application:
Traditional costing method is easy to implement as a single cost driver is set for all activities and
overheads are simply divided into fixed and variable overheads. Activity based costing is difficult to
implement because it involves choosing a suitable basis of absorption and absorbing overheads on
that same basis is a complicated and time-consuming exercise. Additionally, in some cases it
becomes difficult to determine a proper basis for the allocation of an activity.

3. Scope:
Traditional costing can only be used for the absorption of manufacturing overheads but activity
based costing can effectively be used to allocate manufacturing as well as non-manufacturing
overheads like selling, administration etc. This is because activity based costing considers the actual
center of cost for the period cost and then allocates it.

4. Management use:
The figures extracted by traditional costings can be included into cost figure of statement of profit or
loss because it only inculcates product costs but activity based costing can only be used
for managementpurposes. The main reason being activity based costing is based on the subjectivity
of the user and two users may not find a cost metric suitable for the same activity. However, activity
based costing can be actively used by the management of a company to make better cost pools and
allocate costs more accurately.

5. Effectiveness of operations:
Activity based costing improves business processes in long term. This is because management of a
company needs to investigate deeply into production activities and related costs. This highlights the
reasons for certain costs being incurred, which can ultimately help control and manage these costs.
Traditional costing does not compel management to look for different cost centers and so it
becomes difficult for management to gather incremental data about production activities.
 6. Discuss the use of activity-based costing (ABC). In particular, where can ABC have t_h_e_
_l_a_r_g_e_s_t_ _i_m_p_a_c_t_ _a_n_d_ _w_h_a_t_ _c_a_n_ _A_B_C_ _s_a_y_
_a_b_o_u_t_ _t_h_e_ _f_i_r_m_’s_ _o_p_e_r_a_t_i_o_n_s_?_ _
ANS: Activity Based Costing – 6 Important Uses
(a) Focus on where the cost originates, i.e., the causes of the cost.
(b) Accurate product cost due to understanding of the cost behaviour.
(c) Identifies source of non-value added activity or wasted efforts.
(d) Strategic cost information of which long-term profitability decision for a product can be taken.
(e) Non-financial information regarding quality flexibility and value to the customer can be received.
(f) Improved cost-basis available both at head office and plant level for better decision making.

Activity Based Costing – Need of ABC System by an Organisation

ABC System is needed by an organisation for the purpose of accurate product costing in cases where
–
(i) Production overhead costs are high in comparison to the various direct costs;
(ii) Product range of the organisation is highly diverse;
(iii) Overhead resources used by various products are very different in amounts;
(iv) Volume or quantity of production is not primary driving force for the consumption of overhead
resources.
According to the Willie Sutton Rule, ABC have large impact on those organization or those firms that
have large indirect and support resource expenses, especially when such expenses have been
growing over time as traditional costing assumes that every cost is unit level and cost are similar
which isnot according to ABC. Moreover, large firms have huge diversity. They have large varirty in
products, consumers or processes for e.g. factories that produces high volume standard products
and low volume custom products so in this case also ABC plays an important role. ABC helps in
improving the firm’s performance by increasing profitability and decreasing the costs
https://www.marketing91.com/activity-based-costing-uses-advantages-and-disadvantages/
https://www.economicsdiscussion.net/cost-accounting/activity-based-costing/32575

6. Explain time-driven activity-based costing (TDABC). Compare and contrast TDABC with ABC.
ANS: TDABC is similar to ABC , but it is more simpler, more powerful and easier to update. Time
Driven Activity Based Costing (TBABC) is a costing method that uses the time required to complete
each step in a process to produce a product or deliver a service. So time is the only cost driver as the
cost is depend on how much time we spend on activity.