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Topic15_Asymmetric Info

# The expected toal surplus for both managers and firm

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The expected toal surplus for both managers and firm together = 15 + 15 = \$30 Fixed Wage Contract 32

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(2) With Profit sharing contract, which effort level will be chosen by the manager? With profit sharing, the manger gets Y = 0.5(E(I)) - cost of effort. o Low effort, Y = 0.5*(0.5*20 + 0.5*40) – 0 = \$15. o Medium effort, Y = 0.5*(0.5*40 + 0.5*80) – 10 = \$20 o High effort, Y = 0.5*(0.5*80 + 0.5*100) – 30 = \$15 Profit-sharing or Bonus Contract? 33
Manager will choose: Medium Effort Given that manager chooses Medium Efforts, the firm gets expected profits, E(X) = E(I) – share paid to the managers = 0.5 *E(I) = 0.5*(0.5*40 + 0.5*80) = \$30 Thus with profit sharing total expected surplus for both (managers and firm) combined = 20 + 30 = \$50 Profit-sharing or Bonus Contract? 34

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(3) For the bonus contract the manager gets Y = 0.8(the firm’s income above 40) - the cost of effort. o Low effort, Y = 0. o Medium effort, Y = 0.8(0.5(40-40) + 0.5(80 – 40)) – 10 = 16 - 10 = \$6 o High effort, Y= 0.8(0.5(80 – 40) + 0.5(100 - 40)) – 30 = 40 – 30 = \$10 Profit-sharing or Bonus Contract?
Manager will choose: High Effort. Given that manager chooses High Effort, the firm gets E(X) = E(I) – bonus payments to managers = (0.5*80 + 0.5*100) – 40 = \$50 Note that bonus payment = 0.8[0.5(80-40) + 0.5(100-40)] = \$40. With this, total surplus = 10 + 50 = \$60. Profit-sharing or Bonus Contract?

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(1) With a fixed wage : The manager chooses low effort and gets \$15 and the firm make \$15. Total surplus = \$30. (2) With the profit-sharing : The manager puts medium effort and gets \$20. The expected profits for the firm = \$30. Total = \$50. (3) With the bonus contract : The manager puts high effort and gets \$10 and the expected profits for the firm = \$50. Total = \$60 The Solution
Since bonus contract gives the highest expected profits for the firm, it will choose bonus contract. More generally, even high powered contracts might not be able to generate full efficiency. If managers are risk averse rather than risk neutral, could this have an effect on whether bonus contracts, profit-sharing contracts, or fixed wage contracts are preferred by the parties involved? Comments

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If buyers are uncertain about product quality while sellers know the quality, we have a situation of asymmetric information. This kind of asymmetric information in the market a) Can cause buyers to be risk averse. b) can cause adverse selection. c) can cause inefficiency in that potential gains from trade are wasted. d) b and c. e) All of the above. Quiz
Assume the fixed wage contract provides a salary of \$10. The manager’s net return, Y, is this salary minus the cost of effort. a) With high effort the manager gets the highest net return. b) If the manager maximizes the net return, we expect low effort to be chosen. c) Medium effort would generate losses for the manager. d) None of the above. Quiz

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Assume the bonus contract pays the manager 50% of the firm’s income above 40. If the firm revenue is \$50 with p = 0.6 and \$70 with p = 0.4 under the manager’s chosen level of effort, the firms expected profits is: a) \$58 b) \$40. c) \$49 d) \$9. Quiz
Bad Luck (40%) Good Luck (60%) Low Effort (0) 10 40 High Effort (10) 40 80 a) With a fixed wage of 10 the expected return to the owner exceeds 20. b) If net income is shared 50-50, the owner’s expected return exceeds 30. c) All of the above. d) None Quiz
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The expected toal surplus for both managers and firm 30...

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