Microeconomics (9th Edition) (Pearson Series in Economics)
9th Edition
ISBN: 9780134184241
Author: Robert Pindyck, Daniel Rubinfeld
Publisher: PEARSON
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Chapter 17, Problem 9RQ
To determine
The relevance of principal agent problem.
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As an employer, suppose you find it costly to monitor employee effort 100 percent of the time. What compensation options, in terms of the basis of pay, are available to ensure that you get appropriate levels of employee effort? What factors would you consider in choosing among these options?
What is the principal-agent problem? Have you ever worked in a setting where this problem has arisen? If so, do you think increased monitoring would have eliminated the problem? Why don’t firms simply hire more supervisors to eliminate shirking?
In Chapter 5 of Managerial Economics, Froeb discusses post-investment holdup as a sunk cost problem associated with contract-specific fixed investments. The modern theory of contracts is sometimes called the theory of joining wills, which simply means when parties make an agreement they are joining together to complete an endeavor of mutual interest. The problem with all contracts that endure over time is that not all potential challenges can be anticipated. The idea of joining wills is that parties will attempt to seek accommodations to advance their mutual interest, so long as the return on the invested activity pays off. Froeb illustrates the idea by the example of marriage as a contract.
Review the three scenarios below. Look for which, if any, of these scenarios presents an example of post-investment holdup.
Your firm conducted a search for a new chief financial officer and hired a highly qualified candidate with a yearly salary of $250,000. After six months, the person left to…
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Microeconomics (9th Edition) (Pearson Series in Economics)
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- Answer the following sub-questions using economic theory, the principal agent theory and empirical evidence. Most UK and American CEOs are paid significantly more than the average employee of their firms. Does this fact suggest that CEOs are overpaid? French and German CEOs earn considerably less than US CEOs, does this suggest that US CEOs are overpaid? The firm’s stock market price is uncorrelated with the FTSE100 index. In economic terms, does it make sense to pay the firm’s CEO based on the FTSE100 index? Explain. Taking into account the article by Bebchuk et al “The Wages of Failure”, discuss the advantages and disadvantages of incentive pay and the problems of incentive pay in the case of Bear Stearns and Lehman Brothers. Also discuss reforming incentive pay to deal with the problems unearthed at Bear Stearns and Lehman Brothersarrow_forwardCan the principal agent problem be avoidedarrow_forwardSuppose that the expected value of weekly profits for an ice cream shop, before paying the manager, Amy, is where e is Amy's weekly overtime hours. Amy is risk-neutral but incurs a cost for working overtime. Thus, total expected surplus is What level of effort maximizes total surplus? The value of overtime that maximizes total surplus is e= hours. (Enter your response rounded to one decimal place.) E(T) = 500 + 10e, C(e) = e² E(S) = E(T) - C(e).arrow_forward
- Consider the following situation. Emma (the agent) works for Rachel (the principal). Emma's work has three possible outcomes (that is, profit to Rachel): Profits e=0 $0 p=0.6 $2,000 p = 0.3 $3,000 p=0.1 U= e = 1 p=0.1 p = 0.3 p=0.6 where e = 0 means that Emma puts no effort on her job, and e = 1 means that Emma puts effort on her job. Each cell shows the associated probabilities on each outcome. Emma's utility function is given by √ if she puts no effort, √w-5 if she puts effort, where w the payment from Rachel. If Emn does not work for Rachel, Emma will have an outside option that gives her the utility level of 15. (a) Calculate the expected profits for Rachel on each case that reflects Emma's effort level. Which case does Rachel prefer?arrow_forwardBill has been adjudicated by the court to be mentally incompetent. Any contract that bill would enter into would be void? True or falsearrow_forwardRespond to the question with a concise and accurate answer, along with a clear explanation and step-by-step solution, or risk receiving a downvote.arrow_forward
- Define consideration. Can consideration be illegal for a binding contract? Can consideration be modified in a contract? Is that ethical?arrow_forwardWhat are the assumptions of Arbitrage Pricing Theory (APT) modelarrow_forwardConsider a self employed worker who owns a firm that produces output q which sells for a price of p = 1. Output depends on effort, e, so the production function is q = γe, where γ > 0 is a parameter. Effort reduces utility, and the cost of effort is c(e) = 1 2 e2. Note that there is no principal-agent problem here because the worker is the owner of the firm (and therefore has a claim on all profits), in addition to personally incurring the cost of effort. The self employed worker’s utility is a linear function of revenue net of effort costs, U(e) = q− c(e) = γe− 1 2 e2arrow_forward
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