Question

Consider this situation. Julie is the owner of an airport shuttle. The shuttle transports passengers between Bowling Green and the Nashville Airport. Most customers pay with cash because there is a big discount. Since she is old and spends most of the time in Florida, she hired Mark, as the only employee and driver. Julie is far away from Bowling Green, therefore she has to believe Mark unless there is an unambiguously clear evidence against Mark’s claim/report. Assume that Mark is rational (in economics, rational is synonymous with selfish) and he will always cheat on Julie if doing so is beneficial (increasing his monetary benefits).

     Julie is considering the following five possible compensation methods:

            I)           Pay Mark a flat salary (e.g., $3,500 each month)

            II)         Pay Mark an amount equal to reported revenue less fixed amount

             (e.g., reported revenue less $3,000; negative pay if reported revenue < $3,000)

            III)       Pay Mark a certain percent of sales (e.g., 30% of reported fares from passengers)

4. Pay Mark on an hourly basis (e.g., $25 per hour * Reported work hours)
5. Pay Mark based on the mileage (e.g., $0.30 for each mile added in the mileage gauge)
6. Pay Mark based on his efforts (how hard he works)

Julie is trying to find the best method in avoiding potential cheating by Mark.

Required:

A. Which of the following methods is the best one as far as the owner Julie is concerned? And why?

B. For each of the other 5 methods (the ones you did not choose in A), explain why it is not good for Julie.

Answer 1

A. Considering that Julie is completely dependent on Mark for carrying out services, so it would be wise to pay Mark based on the Mileage. This will ensure the genuineness of the work done by him. This method will also keep Mark motivated to put in efforts to increase mileage to earn more. Further it will also ensure Julie to cross check the amount of Revenue generated from the miles covered, so as to avoid any potential cheating by Mark on this front.  

B. Reasons for not choosing the methods are as follows :-

Pay mark a flat salary - Paying a flat salary would allow mark to potentially under report the revenue and cheat on julie with the cash received.

Pay Mark an amount equal to reported revenue and fixed expenses - in this method mark may report lower revenue.

Certain amount of Sales - Here also mark may report lower revenue and take the under reported revenue entirely instead of having a percentage of the same.

Hourly basis - Since julie has to believe what mark has to say so she won't be able to verify the timing put in by mark.

Efforts based - Since julie has to believe what mark has to say so she won't be able to judge the efforts put in by mark.