Question Seven There are specific applications of the hidden-action or moral hazard model. Consider employment contracts signed between a firm's owners and a manager who runs the firm on behalf of the owners. The manager is offered an employment contract which they can accept and decide how much effort, e ≥ 0, to exert. Suppose that an increase in effort, e, increases the firm's gross profit, not including payments to the manager, but is personally costly to the manager and the firm's gross profit, Пg, takes the following form: Пg = e +ε, ε~N(0,2). Let s denote the salary, which may depend on effort and/or gross profit, depending on what the owner can observe, offered as part of the contract between the owner and manager. Suppose that the manager is risk averse and has a utility function with respect to salary of the form: Aσ² U(W)=μ- 2 a) Derive the optimal result of the owner's expected net profit where there is full information and state what it implies. b) Suppose now that the owner offers a salary to the manager that is linear in gross profit, that is, s(Ig) = a + bПlg where a is the fixed component of salary and b measures the slope or power of the incentive scheme. Derive the manager's optimal result which maximises expected utility considering a case where the owner of the firm cannot observe effort, e and therefore the contract cannot be conditioned on effort and state what it implies. c) Akerlof's 'Market for Lemons (1970)' described an extreme case of the problem for the market for used cars. According to this theory, the market for used cars is much less efficient than it would be under the standard competitive model. Applying the same concept but in the labour market, explain how a degree in economics will help you in the labour market. d) Auctions have received a great deal of attention in the economics literature ever since William Vickery's seminal work in 1961, for which he won the Nobel Prize in economics. Explain the practical relevance of auctions.
Question Seven There are specific applications of the hidden-action or moral hazard model. Consider employment contracts signed between a firm's owners and a manager who runs the firm on behalf of the owners. The manager is offered an employment contract which they can accept and decide how much effort, e ≥ 0, to exert. Suppose that an increase in effort, e, increases the firm's gross profit, not including payments to the manager, but is personally costly to the manager and the firm's gross profit, Пg, takes the following form: Пg = e +ε, ε~N(0,2). Let s denote the salary, which may depend on effort and/or gross profit, depending on what the owner can observe, offered as part of the contract between the owner and manager. Suppose that the manager is risk averse and has a utility function with respect to salary of the form: Aσ² U(W)=μ- 2 a) Derive the optimal result of the owner's expected net profit where there is full information and state what it implies. b) Suppose now that the owner offers a salary to the manager that is linear in gross profit, that is, s(Ig) = a + bПlg where a is the fixed component of salary and b measures the slope or power of the incentive scheme. Derive the manager's optimal result which maximises expected utility considering a case where the owner of the firm cannot observe effort, e and therefore the contract cannot be conditioned on effort and state what it implies. c) Akerlof's 'Market for Lemons (1970)' described an extreme case of the problem for the market for used cars. According to this theory, the market for used cars is much less efficient than it would be under the standard competitive model. Applying the same concept but in the labour market, explain how a degree in economics will help you in the labour market. d) Auctions have received a great deal of attention in the economics literature ever since William Vickery's seminal work in 1961, for which he won the Nobel Prize in economics. Explain the practical relevance of auctions.
Managerial Economics: A Problem Solving Approach
5th Edition
ISBN:9781337106665
Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor
Publisher:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor
Chapter1: Introduction: What This Book Is About
Section: Chapter Questions
Problem 1.2IP
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Transcribed Image Text:Question Seven
There are specific applications of the hidden-action or moral hazard model. Consider employment
contracts signed between a firm's owners and a manager who runs the firm on behalf of the
owners. The manager is offered an employment contract which they can accept and decide how
much effort, e ≥ 0, to exert. Suppose that an increase in effort, e, increases the firm's gross profit,
not including payments to the manager, but is personally costly to the manager and the firm's gross
profit, Пg, takes the following form: Пg = e +ε, ε~N(0,2). Let s denote the salary, which may
depend on effort and/or gross profit, depending on what the owner can observe, offered as part of
the contract between the owner and manager. Suppose that the manager is risk averse and has a
utility function with respect to salary of the form:
Aσ²
U(W)=μ- 2
a) Derive the optimal result of the owner's expected net profit where there is full information and
state what it implies.
b) Suppose now that the owner offers a salary to the manager that is linear in gross profit, that is,
s(Ig) = a + bПlg where a is the fixed component of salary and b measures the slope or power
of the incentive scheme. Derive the manager's optimal result which maximises expected utility
considering a case where the owner of the firm cannot observe effort, e and therefore the
contract cannot be conditioned on effort and state what it implies.
c) Akerlof's 'Market for Lemons (1970)' described an extreme case of the problem for the market
for used cars. According to this theory, the market for used cars is much less efficient than it
would be under the standard competitive model. Applying the same concept but in the labour
market, explain how a degree in economics will help you in the labour market.
d) Auctions have received a great deal of attention in the economics literature ever since William
Vickery's seminal work in 1961, for which he won the Nobel Prize in economics. Explain the
practical relevance of auctions.
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