Sam is semi-retired and owns a small business. He intends to reduce his workload further and retire for good. Assume the firm's payoff and its net income for the year are equal.

Sam intends to hire Tom to manage the operations. Sam wants Tom to work hard. Sam's past experience is that 85 percent of the time, hard work generates a net income (before any manager compensation) of $2,000, while 15 percent of the time it generates $500. Sam's recent experience, when he has not worked hard, is that the $2,000 net income is generated only 15 percent of the time; otherwise, net income is $500.

Tom is risk and effort-averse. His utility for money is equal to the square root of the amount of money received. Tom's disutility for effort is 5.5 if he works hard and 1 if he shirks. His reservation utility is 9. Sam decides to hire Tom offers him a one-year contract, with annual cash compensation of a $100 salary plus 10 percent of net income before manager compensation. Tom immediately accepts. Required Note: Take calculations to two decimals.

a. Show calculations to demonstrate why Tom accepts the position. Will he work hard or shirk?

b. After one year, Sam wants to keep Tom as manager but is worried because net income has only been $500 for the year. For year 2, Sam decides to offer Tom a salary of $50 plus a profit share of 10% of net income before manager compensation. Tom accepts. Show calculations to demonstrate why Tom decides to accept the contract for year 2.