Answered: Paula hires Alfred to manage her store.…

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: Alfredreceives a share x of the store’sprofitsbut no wage.

For which values of x does Paula prefer the Profit-Sharing over the Fixed-Wage contract?
(a) Paula prefers the profit-sharing contract for any x > 3/4
(b) Paula prefers the profit-sharing contract for any x < 11/16
(c) Paula always prefers the profit-sharing contract (that is, she prefers it for any 0 ≤ x ≤ 1)
(d) Paula never prefers the profit-sharing contract (regardless of x, she prefers fixed wage)

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