Groves Mechanism: Applications and Limitations For Susan Martin, President of Elmira Nursery, the crucial weekly operating decision is allocating the firm's 10 gardeners to the firm's two operating divisions, Commercial and Nursery. No other gardeners can be hired.

The Commercial division solicits contracts for landscaping and garden maintenance.

It is widely known that its return is fixed and contracts reflect market. conditions.

Shawn Dempsey, the manager of this division, knows that this division can keep all 10 of the firm's ten gardeners fully occupied at a net profit to the firm of $50 per gardener hour The Nursery division consists of a greenhouse operation that grows plants and shrubs for the commercial market. Its return is uncertain and depends on volatile market conditions. Karen Barton, the manager of this division, believes that, in the current market, the distribution of net profit per gardener hour is uniform over the interval $40 to $55.

This belief is held privately by Karen and is not known to the other members of the senior management team at Elmira Nursery.

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Required Consider each question separately. (1) Suppose Karen's compensation is a function of the reported weekly profits of the Nurs- ery division. Suppose further that Susan allocates gardeners to divisions based on the expected returns estimated by the division managers. If Karen is an expected-value de- cision maker, show that this organization structure will motivate Karen to lie about her division's expected return per gardener hour. (2) Suppose now that Karen's compensation is a function of the reported weekly profits of Elmira Nursery. If Karen is an expected-value decision maker, is there any motivation for Karen to lie about her division's expected return per gardener hour? Explain the dysfunctional consequences of this reward mechanism if the divisional return can be in- fluenced by managerial competence. (3) Suppose Susan has decided to use the Groves mechanism to allocate the gardeners to the two divisions in her business. For Elmira Nursery, the Groves measure for the Nurs- ery division would have the form GN=T(XN)+(X) - KN where (X) = actual weekly profits for the Nursery division, with X, gardeners allocated to this division TC(XC) =forecasted weekly profits for the Commercial division, with Xc gardeners allocated to this division KN a constant independent of the Nursery division's forecasted or actual profits How would use of the Groves measure improve the information elicited from Karen and Shawn? (4) Suppose further that Susan wishes to make G, relevant to Karen by incorporating it into Karen's compensation function. Karen's compensation will be YE=WE + KGN WE K = where y Karen's total compensation Karen's fixed wage = a fixed positive constant GN = the Groves measure for the Nursery division