Assume That the Owners of a Firm Know That the Firm's

Essay

Assume that the owners of a firm know that the firm's profits will depend upon two parameters: (1) how hard the managers work, and (2) the state of the economy. For simplicity, assume that the managers can exert either maximum or minimum effort and that the economy can be either favorable or unfavorable. The profits under various situations are represented by the matrix below.
Favorable Unfavorable
Economy Economy
Maximum Effort 700,000 400,000
Minimum Effort 400,000 200,000
The firm considers there to be an equal probability of either state of the economy. The manager considers the cost of effort to be C = 55,000x, where x = 1 for maximum effort, 0 for minimum effort. The firm is considering the pay scheme described below. Evaluate each alternative in terms of their incentive effects for the manager and their effect on the firm's profitability.
a. a flat salary of $30,000 that is not tied to the firm's performance
b. a bonus of 0 if profit equals 200,000 or 400,000 and a bonus of 120,000 if profit equals 700,000
c. a bonus determined by the formula: B = 0.20(PROFIT - 300,000)
d. a bonus determined by the formula: B = 0.24(PROFIT - 300,000)