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Agency_Prob

# Agency_Prob - Staples’ revenue depends upon Barney’s...

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1 UBC COMM 295 Solution to Moral Hazard/Agency Problem 1. Your firm needs to hire an accountant. There are three types of accountants (1000 of each type): good, medium and bad. The value of the hourly contribution of these accountants towards your firm’s profits equals \$500, \$300 and \$100 respectively. The reservation hourly wage (i.e., opportunity cost) of these accountants equals \$310, \$190 and \$100, respectively. You are unable to distinguish among the three types of accountants. Determine which of the three types of accountants will offer their services to your firm and what you will offer to pay per hour in equilibrium. (Assume you pay the expected value of the accountant’s hourly contribution toward your firm’s profits). What type of problem is this (i.e., moral hazard, adverse selection, signaling, principal-agent, etc.)? 2. Staples recently hired Barney as a store manager. Barney can put in either low effort (a = 0) or high effort (a = 1), but Staples cannot observe Barney’s specific effort choice.
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Unformatted text preview: Staples’ revenue depends upon Barney’s effort as follows: Bad Economy (Prob. =0.5) Strong Economy Low effort (a=0) 150,000 250,000 High effort (a =1) 250,000 500,000 Barney’s utility function is U = w – C(a), where w denotes his wage income, and C(a) = 10,000a is his cost of effort. a) Briefly explain why this employment relationship constitutes an example for the principal-agent problem. b) In the absence of monitoring, can a fixed wage induce Barney to implement high effort (i.e., a = 1)? Briefly explain. c) Suppose that Staples considers offering Barney two different incentive contracts: A. Profit Sharing Contract: Barney receives 5% of the revenue and no fixed wage. B. Bonus Contract: Fixed wage of \$10,000, and a bonus of \$30,000 if revenue equals \$500,000. What level of effort would Barney implement under each contract? d) Given Barney’s respective effort choice you identified in part c), which contract is preferred by Staples?...
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