Goolsbee1e_Solutions_Manual_Ch15

# 15 consider the questions faced by the board and the

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15. Consider the questions faced by the board and the CEO in Problem 14. Assume that, as before, expend- ing modest effort costs the CEO \$300,000. But, assume now that expending high effort costs the CEO \$750,000. a. Draw the extensive form for this game and find the equilibrium. Does the change in the cost of high effort alter the outcome? Explain. b. Demonstrate that the directors cannot improve their outcome by changing the base salary in the profit- sharing plan. c. What is the minimum share of the firm’s profit that will induce the CEO to expend high effort? Goolsbee1e_Solutions_Manual_Ch15.indd 216 Goolsbee1e_Solutions_Manual_Ch15.indd 216 11/15/12 3:10 PM 11/15/12 3:10 PM

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Asymmetric Information Chapter 15 217 Solution Solution 15. a. (\$9 million, \$250,000) (\$6 million, \$700,000) (\$8.8 million, \$450,000) (\$6.1 million, \$600,000) Directors CEO Modest effort Modest effort Effort Effort Profit - sharing Flat The change in the cost of high effort changes the equilibrium payoff to (\$6.1 million, \$600,000). The CEO’s best response is to choose modest effort. Hence, the board of directors’ best choice is to still offer the profit-sharing method of payment. b. Changing the base salary in the profit-sharing plan will not change the CEO’s best response. The base salary is the same whether the CEO makes a modest effort or a lot of effort. Thus, if we assume that x denotes the base salary, then the salary of the CEO is x + \$250,000 if he expends a lot of effort and x + \$400,000 if he makes a modest effort. In summary, the CEO’s best response will always be to ex- pend a modest effort for any value of the base salary x . c. The minimum share of the firm’s profit, X , guaranteed to induce the CEO to expend high effort is the payoff that makes the CEO better off than when he expends modest effort, that is, \$10,000,000 × X + \$200,000 \$750,000 > \$7,000,000 × X + \$200,000 \$300,000 \$3,000,000 X > \$450,000 X > 0.15 Hence, the board must offer at least a 15% share in the firm’s profit to induce the CEO to expend high effort. 16. You have decided to produce a line of moisture-wicking skateboarding clothes. You’re a wonderful designer, but a lousy tailor, and as a result, you decide to hire your roommate (who is a wonderful seamstress) to pro- duce the clothes for you. Is it better for you to pay your roommate by the hour or to pay by the garment? Explain. 16. It is better to pay your roommate by the garment. This scheme would induce your roommate to work harder to increase his earnings and thus your production. The pay-by-the-hour scheme generates moral hazard as it is not in the roommate’s interest to work hard. 17. Princess Buttercup has a multitude of potential suitors. She wishes to separate them into two groups — those who are truly interested in her hand in marriage, and those who are only interested because she’s con- venient, pretty, and rich. Let’s call these two groups “interested” and “nonchalant,” respectively. In an attempt to separate the two groups, Princess Buttercup devises a plan under which potential suitors must slay dragons before coming to the castle to court her.
• Fall '09
• used car, Information asymmetry, Adverse selection, high-quality cars

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