Question

1. 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: uI= I

Her utility, at high effort: ui=I-46.3.

You are considering two compensation packages:

1. Pay a flat salary of $50,000.

1. Assuming a flat salary, calculate the manager’s utility associated with low effort and high effort.
2. Calculate the difference in terms of utility between high effort and low effort. Justify the difference.

2. Profit based compensation.

The labour market is competitive and salaries must at least be 223.6 in expected utility terms. Profits and probabilities (p) associated with low and high effort are listed in the table below.

	Low wheat price (p=0.5)	High wheat price (p=0.5)
Low effort	$50,000	$150,000
High effort	$100,000	$200,000

1. What proportion (x) of the profits will incentivise the manager to apply high effort?
2. Will the manager provide high effort? Justify your answer.

3. Are you better off? Justify your answer.

Answer 1

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