Assignment
1. Answer the following questions AS BÆIEFLV AS POSSIBLE:
(a) Name the condition(s) that guarantee(s) that the wage of the agent increases with the principal‘s gross payoff.
(b) What do Grossman and Hart (1983) propose as an alternative of the first- order approach when dealing with moral haxard with a continuum of feasible actions?
(c) Which measure of executive compensation should we use when estimating the company‘s expected cost of hiring the executive?
(d) How would a shift in demand from firm-specific to general managerial skills affect GEO pay? Explain.
(e) Give two possible explanations for the lack of RPE in the compensation contracts of older/senior GEOs
(f) Why may a GEO agree to work for a salary of $1?
(g) Do you expect GEO‘s pay-performance sensitivity to increase or decrease with the volatility of the firm‘s stock returns. Explain.
(h) What are the implications of the theory of career concerns for the pay- performance sensitivity of junior versus senior GEOs?
2. A principal (she) hires an agent (he) to run a project which has a payoff sS if successful and 0 if unsuccessful, where xS > 0 If the agent receives a wage r and exerts effort a, his utility is ln(ω) - a. The agent can either shirk in which case a = 0 or work hard in which case a = 1. If the agent works hard and the state of the economy is good, then the project is successful with probability 0.6. If the agent shirks and the state of the economy is bad, then the project is successful with probability 0.1. If the agent works hard, but the state of the economy is bad, then the project is successful with probability 0.4. This is also the case if the state of the economy is good, but the agent shirks. The principal is risk-neutral and cares about the payoff of the project net of agent‘s compensation. The agent‘s reservation utility is 0 and does not depend on the state of the economy.
(a) Assume that the principal can observe both the state of the economy and the effort of the agent. Also assume xS = 20.
(i) Suppose that the state of the economy is GOOD. Find the level of effort that the principal would recommend to the agent, the wage received by the agent if the project fails, and the wage received by the agent if the project succeeds.
(ii) Would your answers change if the state of the economy is BAD? If no, why? If yes, how?
(b) Now, assume that the principal can observe the state of the economy, but not the effort exerted by the agent. Also assume that sS is such that the principal finds it optimal to recommend HIGH EFFORT no matter the state of the economy.
(i) Suppose that the state of the economy is GOOD. Find the wage received by the agent if the project fails and the wage received by the agent if the project succeeds. Which of these wages is higher?
(ii) Suppose that the state of the economy is BAD. Find the wage re- ceived by the agent if the project fails and the wage received by the agent if the project succeeds. Which of these wages is higher?
(iii) Find whether the wage received by the agent if the project SUG- GEEDS is higher when the state of the economy is good or when it is bad. So, does it satisfy relative performance evaluation (RPE)?
(iv) Find whether the wage received by the agent if the project FAILS is higher when the state of the economy is good or when it is bad. So, does it satisfy RPE?