Week 12B agency problem solutions

Week 12B agency problem solutions - C295 Week 12b 2010:...

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November 25, 2010 Net Income for Firm Prior to Paying Manager A: Fixed Wage = 20 B: Manager gets 50% of net income Let E(Y) = expected net return for manager = expected compensation – cost of effort Let E( π ) = expected profit for firm = expected net income – manager compensation Fixed Wage (i) Low Effort E(Y) = 20 – 10 = 10 E( π ) = 0.5*(20 + 60) – 20 = 20 (ii) High Effort E(Y) = 20 – 20 = 0 E( π ) = 0.5*(60 + 100) – 20 = 60 The manager will choose low effort even though owner prefers the high effort outcome. The incentives are not aligned. Manager’s Compensation is 50% of Net Income (i) Low Effort E(Y) = 0.5(20/2) +0.5(60/2) – 10 = 10 E( π ) = 0.5(20/2) +0.5(60/2) = 20 (ii) High Effort E(Y) = .5(60/2) +0.5(100/2) – 20 = 20 E( π ) = 0.5*(60/2 + 100/2) = 40 The manager will choose high effort, and this is what the owner wants. The incentives are now aligned. Bad Luck: 50%
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This note was uploaded on 01/03/2011 for the course COMM 290 taught by Professor Brian during the Winter '09 term at The University of British Columbia.

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Week 12B agency problem solutions - C295 Week 12b 2010:...

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