Question

3.Assume that you have inherited the family farm while mid-way through your undergraduate degree. The farm produces wheat. You want to complete your major in economics and want to employ a manager.The manager relies only on the income I you offer and she is assumed to maximise expected utility.Her utility, at low effort: ?(?)=√?Her utility, at high effort: ?(?)=√?−46.3.You are considering two compensation packages:

(a)Pay a flat salary of $50,000.

(i)Assuming a flat salary, calculate the manager’s utility associated with low effort and high effort.

(ii)Calculate the difference in terms of utility between high effort and low effort. Justify the difference.

Answer 1

i)

Utility at low level of effort is given as

Set I=$50000

Utility at hight level of effort is given as

Set I=$50000

ii)

Difference in utility=Utility at high effort-Utility at low effort

Difference in utility=177.3068-223.6068=-46.30 utils

We can see that the utility is lower with high level of effort provided income is same. Negative difference indicates the dis-utility of high effort. A person will go for high effort only if he is compensated for his disutility in terms of income i.e. he is offered a higher income.