University of St.
Gallen
Department of Economics
Economics 5,262
Personnel Economics
Fall 2010
Homework Assignment 1
This homework assignment is based on the topics that we discussed during the first six weeks
of the course: setting hiring standards, recruitment, investment in skills, managing turnover,
decision making, organizational structure, and job design. Although this is a group assignment,
I encourage you to first work on it on your own, and then meet with your group members to
compare results, reconcile any differences in solutions, and decide on the final version of the
answers that you would like to submit as a group. Please make sure to include the names of all
people in your group on the cover page.
The assignment is due on Wednesday, November 24, 2010, at the beginning of the class.
Problem 1
Calvin's productivity is always €200,000. Hobbes's productivity is high (€300,000) with
probability ½, and low (€100,000) with probability ½. All human capital for both is purely
general. You do not know until after the first period if Hobbes is high or low productivity.
There are two periods, no discounting, and firms are risk neutral.
a) Is Calvin or Hobbes a better hire? Explain.
b) Now assume that whether or not Hobbes turns out to be high productivity does not become
public information. Only you find out after period one. Would you be willing to pay more to
Calvin or to Hobbes in period one? What would be Hobbes's market value in period one?
Which one is a better hire now? Explain.
Problem 2
Advanced Tood Systems Corporation has two divisions: Manufacturing and Sales. Tood is an
expensive semiconductor-based device that looks high-tech and performs no useful function.
These properties make toods very popular with corporate executives. In the tood industry,
when a new worker is hired, both she and her supervisor are equally ignorant about her
ability. There is no skill involved in tood making and marketing; however, natural ability
matters a great deal. An individual assigned to marketing either sells 12 toods a year or she
sells nothing. Similarly, a production worker is either able to produce 12 toods a year or she is
not able to produce any toods at all.
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It is known that:
• Everybody capable of selling toods is capable of making them
• One out of four people can both sell and make toods
• Two out of four people are capable of making toods
Part I
A probationary period under expensive managerial supervision is necessary in order to learn
an individual's type. The costs associated with the probationary period in manufacturing are
$10,000. In other words, at a cost of $10,000, the firm can learn if a particular worker is
capable of producing toods. In order to evaluate the individual's marketing ability, a more
expensive screening procedure is needed. It costs $30,000 to find out if a person is able to sell
toods. Currently, this firm is hiring entry level workers only into manufacturing. Those who
do not show themselves as able toodmakers are dismissed after probation. Some of the able
toodmakers are retained in manufacturing, while others are given an opportunity to do
probation in marketing. That is, they are screened for ability to sell toods, at a cost of $30,000
to the company. Those who fail in marketing are sent back to the tood manufacturing division.
Which of the following options best describes your opinion about this policy? Explain.
a) The firm will do better by hiring some of the workers directly into marketing. It makes
little sense to take an able toodmaker from manufacturing and send her to costly marketing
probation knowing that she will fail there with probability ½.
b) The company will do better by firing workers who failed in marketing.
c) The firm can improve its profits by hiring workers only into marketing, where their ability
to sell toods is tested, and then transferring some of them into manufacturing.
d) The firm is following the optimal screening strategy.
Part II
Recently, Advanced Tood Systems Corporation implemented a new computerized sales
monitoring system. As a result, screening costs for marketing abilities declined to $8000.
Given the availability of cheaper screening in marketing, which of the following options best
describes your opinion about the firm's policy? Explain.
a) The firm should test all new hires regarding their ability to sell toods, and those who can
sell toods should be assigned to marketing or manufacturing. Nobody should be subjected to
probation that only screens for ability to make toods.
b) If the firm needs to hire x and y new workers for marketing and production, respectively, it
should give only marketing screening to 4x individuals and only manufacturing screening to
2y individuals.
c) The firm can improve its profits by hiring workers only into marketing and then
transferring some of those who failed marketing probation into manufacturing probation.
d) The old probation system is optimal under the new circumstances.
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Problem 3
You run a company, GizmoNet, that produces gizmos. Gizmos hook onto Nintendo Game
Boys (hand-held electronic game players), allowing users to access the Internet using wireless
communication protocols. Thus, they turn Game Boys into hand-held web browsers.
Your company hires software engineers, who are employed for three periods. In period one,
they must train at the company. In this period their total productivity is ¥10M (million), and
training costs are ¥8M. In periods two and three (after the training), productivity is ¥17M and
¥19M, respectively. An engineer who received no training would have productivity of ¥10M
at any other firm in all three periods.
Engineers can quit after the training (and always get a job offer at other firms). If they do so,
their productivity at other firms is ¥2M lower than at GizmoNet in each of the last two
periods. Assume no discounting.
a) Is the training a good investment? Is it general or firm-specific human capital? Explain.
b) Suppose that the labor market is competitive, so that the firm must earn zero profits from
hiring an engineer. If so, what set of salaries W1, W2, W3 must the firm offer to guarantee that
the total return on the training investment is maximized? To choose an answer if you have
more than one possibility, pick the feasible solution that maximizes W1 (because software
engineers are impatient and risk averse, so all else equal they would like to be paid as soon
as possible).
Hint: First figure out what has to happen to maximize the return on investment. Then figure
out any constraints on pay, etc. Only then figure out who should invest and get the return (the
worker or firm), and to what extent.
c) Who pays for the training investment, and who earns the return on the investment? Explain.
d) Suppose now that the firm finds out that there are also less able software engineers (the
group described above consists of the more able). Less able engineers can earn ¥4M in any
period at another firm. GizmoNet does not want to hire less able engineers if possible.
Engineers know which type they are, but the firm cannot tell at hiring. Less able engineers
can always be detected by the firm after period one and fired. However, they can take
GizmoNet to court for wrongful termination. They win these cases ¼ of the time, and lose
them ¾ of the time. If they win, your firm must reinstate them and pay W2, W3 in periods two
and three. If they lose, they move on to firms that pay them ¥4M. Ignore legal costs and court-
imposed fines.
Give one salary profile W1, W2, W3 that deters less able engineers from applying to GizmoNet,
but still attracts more able engineers (there is more than one possible solution). Make the
engineer pay for the training – charge him or her for the cost ¥8M – to keep things simple.
Make sure that it provides zero profits for the firm. Explain why this profile works.
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Problem 4
Floor-A-Day is a disposable paper floor manufacturing firm, operating in a competitive
industry with several firms that offer very similar wages and benefits to their workers. Your
firm has a policy not to match outside offers made to workers currently employed by the firm.
Mr. Nosweeper, a VP for floor pattern development, suggested that it will be profitable for the
firm to change the policy and to match all offers. He supported his argument with the
following facts:
1. These who quit Floor-A-Day accept a job elsewhere that pays on average only 4% more
than what they were making at their old job.
2. The cost of hiring replacement for a worker is 40% of her annual wage, thus a 4% wage
increase is a small price to pay for retaining a worker.
3. The turnover rate in the firm is 10% a year, thus Mr. Nosweeper argued that the cost of the
proposed policy change cannot possibly exceed 0.4% of wage bill.
Ms. Smith, a brilliant mind who came up with the famous marketing slogan "a floor a day
keeps the dirt away", objected to the change in offer matching policy. She argued forcefully
that:
a) Proposed offer matching policy may increase the wage bill by much more than 0.4%. (Ms.
Smith assumed that some workers may require a wage premium of more than a few percents
in order to be lured away by other employers.) What was her argument?
b) A policy of matching offers can actually increase turnover in the firm as well as the wage
bill. (Ms. Smith assumed that looking for a new job is time consuming, and thus costly for the
workers. She also assumed that a worker who starts her job hunt does not know with certainty
the best offer she will eventually receive.) What was her argument?
c) Ms. Smith pointed out which data can be collected in order to determine if a change in offer
matching policy would benefit the firm. What data would you need to make a decision
regarding the change in offer matching policy. How can this data be obtained?
Problem 5
Consider the model of decision making with hierarchical vs. flat organizational structures
discussed in class. Assume that the payoff to a "good" project is X > 0, and the payoff to a
"bad" project is Y < 0. There are two types of project evaluation that are available. The tough
evaluation has accuracy T, where 0 < T < 1; that is, the probability of making a correct
decision is T, and the probability of making a mistake is 1 − T. The lenient evaluation has
accuracy L, where 0 < L < T < 1.
a) If you have a hierarchical organization (two layers of project evaluation), would it be better
to use a tough evaluation at the first stage and lenient evaluation at the second, or vice versa?
Explain the effects on the probabilities of each type of outcome (false positives, etc.). Also
discuss intuitively the answer if the evaluation costs (time and other resources) are higher for
a tough review than for a lenient one.
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b) Under some circumstances, a hierarchical structure is preferred; under others, a flat
structure is preferred. How is the choice between these two alternatives affected by the
following?
- X (payoff on good projects)
- Y (loss on bad projects)
- q (probability of good project)
- T or L (accuracy of decisions)
c) Consider a third kind of organizational structure, a "reverse hierarchy": at the second stage,
instead of re-checking projects that are accepted at the first stage, the firm re-considers those
projects that were rejected at the first stage. What would be the effects of such an approach on
one given new idea (not overall)? What kind of firm might consider this model (explain this
part intuitively)?
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