Paula hires Alfred to manage her store. The left column of the table below shows Alfred’s possible effort levels—low and high. Alfred’s personal disutility in terms of dollars depends on his effort level is shown in the second column. The two right columns show the different profits to Priscilla (before paying Alfred’s salary and ignoring his cost of effort) under Low- and High- demand conditions. Effort Level Alfred’s Cost of Effort Low Demand Profit High Demand Profit Low $0 $20 $60 High $10 $60 $100 It is equally likely that demand will be High or Low: chances are 50/50, regardless of how much effort Alfred exerts. They consider two possible contracts: i. Fixed Wage: Alfred receives a fixed wage of $15 ii. Profit Sharing: Alfred receives a share x of the store’s profits but no wage. Assume, to simplify matters, that both Alfredand Paulaare risk neutral. Imagine Paula and Alfred have a third contract option: Alfred can pay a license fee, F, to operate Paula’s store, in which case he will be the residual claimant (he will get all profits after paying the license fee). Exerting high effort still costs him the equivalent of $10, though. Which of the following alternatives is correct? (a) Alfred chooses low effort under the License Fee contract if F = $80 (b) Alfred chooses low effort under the License Fee contract for any F ≥ $0 (c) Alfred chooses high effort under the License Fee contract if F = $40 (d) Alfred only chooses high effort under the License Fee contract if F ≥ $40

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Paula hires Alfred to manage her store. The left column of the table below shows Alfred’s possible
effort levels—low and high. Alfred’s personal disutility in terms of dollars depends on his effort
level is shown in the second column. The two right columns show the different profits to Priscilla
(before paying Alfred’s salary and ignoring his cost of effort) under Low- and High- demand
conditions.

Effort Level Alfred’s Cost of Effort Low Demand Profit High Demand Profit
Low $0 $20 $60
High $10 $60 $100

It is equally likely that demand will be High or Low: chances are 50/50, regardless of how much
effort Alfred exerts.

They consider two possible contracts:
i. Fixed Wage: Alfred receives a fixed wage of $15
ii. Profit Sharing: Alfred receives a share x of the store’s profits but no wage.

Assume, to simplify matters, that both Alfredand Paulaare risk neutral.

Imagine Paula and Alfred have a third contract option: Alfred can pay a license fee, F, to operate
Paula’s store, in which case he will be the residual claimant (he will get all profits after paying the
license fee). Exerting high effort still costs him the equivalent of $10, though. Which of the
following alternatives is correct?
(a) Alfred chooses low effort under the License Fee contract if F = $80
(b) Alfred chooses low effort under the License Fee contract for any F ≥ $0
(c) Alfred chooses high effort under the License Fee contract if F = $40
(d) Alfred only chooses high effort under the License Fee contract if F ≥ $40

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