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Topic15_Asymmetric Info

# On the other hand if they put high efforts they get

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On the other hand, if they put high efforts , they get 0.5(0.6*60+ 0.4*100) 20 = \$18 Since high efforts yield higher incomes for the managers, they put high efforts . As a result, the firm’s expected profits, E(X) = E(I) profit share paid to managers = \$38. 25

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Example With profit sharing (and consequently providing incentives to put high efforts to the managers), the firm gets higher expected profits (=\$38) than with fixed wage (=\$20). Managers also get \$18 (with high efforts) under the profit sharing, higher than \$10 that they get under fixed rate. Thus profit sharing is more efficient than fixed rate as total surplus is higher (and both are better off). 26
Example The agency ―problem‖ is the inefficiency from a fixed wage. With fixed rate contract, the managers bears no risk; all the risks falls on the firm. In this case the agency problem can be eliminated using profit sharing. In more realistic cases profit sharing might help but cannot eliminate the agency problem. 27

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The manager’s effort is given in the left column. Each cell shows the net income or revenue to the firm (without subtracting wage payments and the manager’s cost of effort): Bad Luck Good Luck Low Effort 20 40 Med. Effort 40 80 High Effort 80 100 Another Example 28
The manager’s cost of low effort is \$0, the manager’s cost of medium effort is \$10, and the manager’s cost of high effort is \$30. Bad luck and good luck each have a 50% probability. The manager and the owner are both risk- neutral they care about the expected value of their respective benefits. Another Example 29

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