Chapter 21

Multiple Choice Questions

1. Your notebook computer’ s hard drive recently crashed, and you decide to take it to a local
repair technician to have it fixed. In this relationship,
a. you are the agent. [the agent typically is the party actually performing the work.]
b. the technician is the principal. [the principal typically is the party contracting an
agent to perform the work.]
c. the technician is the agent. [correct; the technician is being contracted by you, the
principal, to do the work.]
d. no principal-agent relationship exists. [assuming that the repair technician has any
interests that are not identical to yours, a principal-agent relationship exists.]

2. A good compensation scheme

a. maximizes the agent's utility. [the goal of a compensation scheme is to maximize the
principal’s profit.]
b. anticipates how an agent will game the scheme. [correct; agents may find ways to
maximize their profit in ways not anticipated by the principal.]
c. does not subject a risk-averse agent to risk. [incentive compensation usually
involves some risk for the agent, for which he or she has to be compensated.]
d. accompanies centralized decision-making authority. [compensation schemes are
especially important when decision-making authority is decentralized.]

3. Principal-agent relationships
a. reduce monitoring costs. [principal-agent relationships are often characterized by
high monitoring costs and thus often rely on incentive pay.]
b. occur because managers have good information about employees. [principal-agent
relationships exist in many environments, including ones where principals have
very little information about their employees.]
c. are not related to asymmetric information. [agents having better information about
their capabilities and actions is typical of principal-agent problems.]
d. are subject to moral hazard problems. [correct; principals may be unable to observe
or monitor agents’ actions.]

4. All of the costs associated with a principal interacting with an agent are called
a. opportunity costs [these are the costs of foregone opportunities.]
b. agency costs [correct; these include the costs of combatting moral hazard and
adverse selection]
c. monitoring costs [this is just one type of cost associated with principal-agent
relationships.]
d. sunk costs [these are costs that do not vary with the consequences of your decision.]

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5. Principal-agent problems
a. occur when firm managers have more incentive to maximize profit than
shareholders do. [the problem generally occurs because the manager has less
incentive to maximize profit.]
b. help explain why equity investments are an important financing source for firms.
[???]
c. would not arise if firm owners had complete information about the actions of the
firm’s managers. [???]
d. are increased as more information is shared between the parties. [reducing
information asymmetry also reduces principal-agent problems.]

6. In order to create an effective incentive compensation scheme, you must have

a. adequate performance measures. [correct; compensation schemes tie rewards to
performance and therefore require that performance be reliably measured.]
b. unlimited funds. [incentive compensation schemes align the incentives of the agent
with that of the principal, but this does not require unlimited funds.]
c. a flat management structure. [a specific management structure is not a precondition
for an effective compensation scheme.]
d. None of the above [one of the above answers is correct;]

7. Decentralization of decision-making authority is consistent with which of the following?

a. A trend of stronger, more active CEOs. [this would be consistent with centralization
of authority]
b. Shrinking costs of computing bandwidth, which allows information to be
inexpensively aggregated from geographically diverse business units. [When
information is easier to aggregate, centralized decision making authority becomes
easier to sustain.]
c. Development of microcomputing resources at the corporate, division, and employee
level. [correct; this provides decision-making tools at each level of a corporation,
reducing the need to centralize decision-making authority.]
d. Reduction in the use of incentive compensation. [decentralization of authority is
generally accompanied with increased reliance on incentive compensation.]

8. A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5
units/year. High productivity employees are willing to work for $100/year while low
productivity employees are willing to work for only $50/year. To screen out the low
productivity employees, the firm should
a. offer a salary of $100. [Both kinds of employees would accept this salary.]
b. offer a salary of $75 plus $5/unit commission. [Low productivity employees would
not be screened out as they would earn more than $50.]
c. offer sales commission of $10/unit. [Low productivity employees would not be
screened out as they would earn $10 on each of five units.]
d. offer a sales commission of $20/unit, on sales above 5 units. [correct; This would
sufficiently reward high productivity employees but pay low productivity
employees only $20, screening them out.]

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9. You own a retail establishment run by a store manager who receives a flat salary of $80,000.
If you set up another store as a franchise with incentive compensation to the franchisee,
what would be a reasonable total compensation range that the franchisee could earn?
a. $80,000 [the franchisee’s compensation should vary with performance.]
b. $40,000– $80,000 [this range would result in expected compensation below
$80,000 and thus would be insufficient to entice the franchisee to participate.]
c. $60,000– $100,000 [correct; this would allow the franchisee to earn an average
salary similar to the manager but still allow it to vary with performance.]
d. $80,000– $100,000 [If a manager requires total compensation of $80,000, then the
franchisee should earn roughly $80,000 on average.]

10. In the magazine Budget Travel , a hotel maid admits, “ I cut corners everywhere I could.
Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would
do. Rather than scrub the tub with hot water, sometimes it was just a spray and- wipe kind of
day.… After several weeks on the job, I discovered that the staff leader who inspected the
rooms couldn’t tell the difference between a clean sink and one that was simply dry, so I
would often just run a rag over the wet spots.… I apologize to you now if you ever stayed in
one of my rooms.” Which of the following organizational forms is more likely to have caused
this kind of shirking?
a. Franchising: where the hotel managers are the owners of the hotel (franchisee) and
pay a fixed franchise fee [As owners, hotel managers receive the profit of the hotel
as earnings and thus have a lot of incentive to maintain the quality of the hotel.]
b. Company-owned hotels [correct; As managers do not share (as much) in the profits
of the hotels, they have less incentive to monitor quality than the other two
organizational forms.]
c. Franchising with a sharing contract, where the hotel managers are the owners of the
hotel (franchisee), but they pay a smaller fixed fee to the franchisor, but share
revenue with the franchisor. [As owners, hotel managers’ earnings vary with the
profit of the hotel, providing a lot of incentive to maintain the quality of the hotel.]
d. None of the above [incentives to shirk vary with organizational form.]