Consider a owner-manager problem in which πgross = 2e + ε [manager has control over e, ε are factors outside of manager’s control, ε~N(0,σ2 )] The owner pays the manager a salary of s out of the gross profits. Manager’s cost of effort = e2 /2. Manager has constant risk aversion utility function. σ 2 = 4 A = 1 a) What is the first-best outcome for manager utility, manager effort, and net profits of the owner? b) Now consider that the owner cannot observe manager effort and offers a salary tied to gross profits: s(πgross) = a + b πgross What is the second-best outcome for manager utility, manager effort, and net profits of the owner?

Consider a owner-manager problem in which πgross = 2e + ε [manager has control over e, ε are factors outside of manager’s control, ε~N(0,σ2 )] The owner pays the manager a salary of s out of the gross profits. Manager’s cost of effort = e2 /2. Manager has constant risk aversion utility function. σ 2 = 4 A = 1 a) What is the first-best outcome for manager utility, manager effort, and net profits of the owner? b) Now consider that the owner cannot observe manager effort and offers a salary tied to gross profits: s(πgross) = a + b πgross What is the second-best outcome for manager utility, manager effort, and net profits of the owner?

Managerial Economics: A Problem Solving Approach

5th Edition

ISBN:9781337106665

Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Publisher:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Chapter17: Making Decisions With Uncertainty

Section: Chapter Questions

Problem 17.5IP

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