Suppose you are running a construction company and are in the process of signing a new contract with a lumber supplier. Getting lumber to a work site on time is critical and based on two things. First is the effort exerted by the lumber supplier and second how fast the shipper of the lumber will get the lumber to the construction site which involves some randomness. The lumber supplier can exert a high or low level of effort. If they exert a high level of effort they will produce the lumber quickly and there is then a 75% chance the shipper can get it to the construction site on time, and only a 25% chance that the shipper will be slow, and the lumber will arrive late. If the lumber supplier exerts a low level of effort, they will take a long time to produce the lumber and there is no chance that it will ship on time. If the lumber supplier exerts low effort it costs them zero dollars, but if high effort is exerted then it costs six thousand dollars in extra resources. The lumber company also has a standing job at the local paper mill that is not time sensitive and would earn the lumber supplier five thousand dollars for sure. Use this information to answer the following questions. For simplicity, assume that the construction company always makes a profit. If you can observe effort what is the minimum you would pay the lumber supply company to ensure they exert a high level of effort? Suppose now you cannot observe the effort of the lumber supply company. What is the minimum bonus that you could provide for on-time delivery that would incentivize the supplier to exert a high level of effort?:
Suppose you are running a construction company and are in the process of signing a new contract with a lumber supplier. Getting lumber to a work site on time is critical and based on two things. First is the effort exerted by the lumber supplier and second how fast the shipper of the lumber will get the lumber to the construction site which involves some randomness.
The lumber supplier can exert a high or low level of effort. If they exert a high level of effort they will produce the lumber quickly and there is then a 75% chance the shipper can get it to the construction site on time, and only a 25% chance that the shipper will be slow, and the lumber will arrive late. If the lumber supplier exerts a low level of effort, they will take a long time to produce the lumber and there is no chance that it will ship on time.
If the lumber supplier exerts low effort it costs them zero dollars, but if high effort is exerted then it costs six thousand dollars in extra resources.
The lumber company also has a standing job at the local paper mill that is not time sensitive and would earn the lumber supplier five thousand dollars for sure. Use this information to answer the following questions.
For simplicity, assume that the construction company always makes a profit.
If you can observe effort what is the minimum you would pay the lumber supply company to ensure they exert a high level of effort?
Suppose now you cannot observe the effort of the lumber supply company. What is the minimum bonus that you could provide for on-time delivery that would incentivize the supplier to exert a high level of effort?:
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