Consider a risk neutral employer and a risk neutral employee. The employee can e
ID: 3298394 • Letter: C
Question
Consider a risk neutral employer and a risk neutral employee. The employee can either work hard or not. Let L for low effort or H for high effort correspond to its effort level. If the employee exercises low efforts, then it has an associated cost of 3 to him.But he generates profits for the employer of 8 with propability .5 and 0 with probability of .5 . If the employee exercises low efforts, then it has an associated cost of 4 to him. But he generates profits for the employer of 8 with probability .75 and 0 with probability .25 . Assume that the employee maximizes his pay minus his costs and it has an outside opportunity of 0 (no effort no rewards).
If the employer can only offer a take or leave it offer before observing the effort level:
1. Set up the problem the employer faces
2. Set up the problem the employee faces
3. Can the employer offer a wage to induce high efforts?
4. If the employee is willing to wait after the employer sees the outcome to get paid (i.e a bonus scheme) would your answer change? If so, how?
5. If the employer can observe the effort level before he pays his employee, what should he do?
Explanation / Answer
1) For the case of low effort The employer's case:
Total gain= (-3)+(8*0.5+0*0.5)=-3+4+0=1
for the case of high efforet
Total gain= (-4)+(8*0.75+0*0.25)=-4+6+0=2
2) since this is a risk neutral problem and so the same situation persists for Employ as to employer
3)Employer Can offer more wage but that will impact his/her gain and if 1 rs increase in wage for high performance makes the gain equal for the employer irrespective of H or L efforts so the employer has a chance to increase the wage upto less than 1 unit to optimize his gain
4. )If the employee is willing to wait after the employer sees the outcome to get paid (i.e a bonus scheme) would your answer change? Yes since the employer now has a chance to see the efforts and increase the wage.
5) in this case the employer should increase the wage if he/she can see the effort level and the maximum he can increase is upto 1 unit