Chapter 7, Problem 71P

Based on Grossman and Hart (1983). A salesperson for Fuller Brush has three options: (1) quit, (2) put forth a low level of effort, or (3) put forth a high level of effort. Suppose for simplicity that each salesperson will sell $0, $5000, or $50,000 worth of brushes. The probability of each sales amount depends on the effort level as described in the file P07_71.xlsx. If a salesperson is paid w dollars, he or she regards this as a “benefit” of w^1/2 units. In addition, low effort costs the salesperson 0 benefit units, whereas high effort costs 50 benefit units. If a salesperson were to quit Fuller and work elsewhere, he or she could earn a benefit of 20 units. Fuller wants all salespeople to put forth a high level of effort. The question is how to minimize the cost of encouraging them to do so. The company cannot observe the level of effort put forth by a salesperson, but it can observe the size of his or her sales. Thus, the wage paid to the salesperson is completely determined by the size of the sale. This means that Fuller must determine w₀, the wage paid for sales of $0; w₅₀₀₀, the wage paid for sales of $5000; and w_50,000, the wage paid for sales of $50,000. These wages must be set so that the salespeople value the expected benefit from high effort more than quitting and more than low effort. Determine how to minimize the expected cost of ensuring that all salespeople put forth high effort. (This problem is an example of agency theory.)