Your business generates the following profits (these are stated before compensation is paid to the manager):

You see that profit depends on both the level of effort chosen by the manager and the level of demand. The demand level is random, and the probabilities of each demand level are shown. So with low effort, expected profit is $10 million; with high effort, it is $12 million. The manager has a utility function that is either
Utility = (Wealth)0.5 if effort is low or
Utility = (Wealth)0.5 ˆ’ 100 if effort is high
Thereforeˆ’100 is the disutility of effort. You are interested in maximizing the expected profit after deduction of compensation. You consider three different compensation packages:
€¢ A fl at salary of $575,000
€¢ A payment of 6% of profit
€¢ A fl at payment of $500,000 plus half of any profit in excess of $15 million Which compensation do you choose?

Transcribed Image Text:

Low Demand 0.3] $5 million Medium Demand 0.4] $10 million $12 million High Demand [0.3] $15 million $17 million Low effort High effort 7 million