Question

Investment and Work Effort: Suppose that Lisa must decide whether or not to invest $40,000 in a new computer system for her company. If she buys the system, she must also hire a technician, Bart. The effect on the firm’s revenues depends on Bart’s effort. If Bart puts in high effort (H) in working with the new system, then revenues increase by $120,000. If Bart puts in low effort (L) then revenues increase by only $50,000. Bart has disutility of $0 for low effort and $10,000 for high effort.

1. Suppose that Lisa pays Bart a salary of $60,000 regardless of his effort. In this case, will Lisa make the investment?

2. Suppose that Lisa writes a (legally binding) contract with Bart under which Bart gets a base salary of $45,000 regardless of effort and a bonus of $15,000 if he puts in high effort. Will Lisa now make the investment in this case? Would she if the cost of the investment was $70,000?

Answer 1

Answer

1.

If Lisa pays a salary of $60000 regardless of the Bart's efforts, her total cost = $40000 + $60000 = $1,00,000

Since, Bart will get the same salary irrespective of his efforts, he will prefer to not put in efforts since it gives him minimum disutility.

Thus, Lisa's total revenue = $50000

Since, Total Revenue < Total Cost, Lisa will not make this this investment.

2. (a)

After the contract, Bart would always put in high efforts in order to earn the bonus.

Thus, Lisa's Total Revenue after the contract = $1,20,000

Lisa's total Cost when bonus is also received by Bart = $40000 + $45000 +15000 = $1,00,000

Since,  Total Revenue > Total Cost, Lisa will make this this investment.

2. (b)

Lisa's Total Cost when cost of initial investment is $70000 = $70000 + $45000 +15000 = $1,30,000

Lisa's Total Revenue after the contract = $1,20,000 [same as 2 (a)]

Since, Total Revenue < Total Cost, Lisa will not make this this investment.