Paula hires Alfred to manage her store. The left column of the table below shows Alfred’s possible effort levels—low and high. Alfred’s personal disutility in terms of dollars depends on his effort level is shown in the second column. The two right columns show the different profits to Priscilla (before paying Alfred’s salary and ignoring his cost of effort) under Low- and High- demand conditions. Effort Level Alfred’s Cost of Effort Low Demand Profit High Demand Profit Low $0 $20 $60 High $10 $60 $100 It is equally likely that demand will be High or Low: chances are 50/50, regardless of how much effort Alfred exerts. They consider two possible contracts: i. Fixed Wage: Alfred receives a fixed wage of $15 ii. Profit Sharing: Alfred receives a share x of the store’s profits but no wage. Assume, to simplify matters, that both Alfredand Paulaare risk neutral. Assume Paula offers the fixed wage contract. Are Paula’s and Alfred’s incentives aligned? (a) Incentives are aligned: Paula wants Alfred to choose low effort, and he chooses low (b) Incentives are not aligned: Paula wants Alfred to choose high effort, but he chooses low (c) Incentives are aligned: Paula wants Alfred to choose high effort, and he chooses high (d) Incentives are not aligned: Paula wants Alfred to choose low effort, but he chooses high

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Paula hires Alfred to manage her store. The left column of the table below shows Alfred’s possible
effort levels—low and high. Alfred’s personal disutility in terms of dollars depends on his effort
level is shown in the second column. The two right columns show the different profits to Priscilla
(before paying Alfred’s salary and ignoring his cost of effort) under Low- and High- demand
conditions.

Effort Level Alfred’s Cost of Effort Low Demand Profit High Demand Profit
Low $0 $20 $60
High $10 $60 $100

It is equally likely that demand will be High or Low: chances are 50/50, regardless of how much
effort Alfred exerts.

They consider two possible contracts:
i. Fixed Wage: Alfred receives a fixed wage of $15
ii. Profit Sharing: Alfred receives a share x of the store’s profits but no wage.

Assume, to simplify matters, that both Alfredand Paulaare risk neutral.

Assume Paula offers the fixed wage contract. Are Paula’s and Alfred’s incentives aligned?
(a) Incentives are aligned: Paula wants Alfred to choose low effort, and he chooses low
(b) Incentives are not aligned: Paula wants Alfred to choose high effort, but he chooses low
(c) Incentives are aligned: Paula wants Alfred to choose high effort, and he chooses high
(d) Incentives are not aligned: Paula wants Alfred to choose low effort, but he chooses high

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