Week 10 Answers: The Principal - Agent Problem

Question 1 ( It might be a good idea to go over the ' Investors as stakeholders: the principal-agent
problem' text and video in the week 10 ICL material (10.3 of the week 10 ICL).

Scenario : Cool Tiles Pty Ltd is an upstart manufacturer of roofing tiles that absorb less solar energy
than conventional tiles, reducing household cooling costs. The shareholders of Cool Tiles must decide
on a compensation package for their new CEO. This CEO can exert either high or low effort in her job.
If she exerts high effort, Cool tiles is more likely (but not certain) to earn a high profit, but exerting
effort is costly for her. The shareholders care only about maximising their average (or expected)
profit, net of the CEO’s pay.

Expected profit can be calculated as:

% chance of high profit x high profit amount + % chance of low profit x low profit amount

Thus, in the low-effort case, expected profit (before subtracting CEO pay) is 80% x $1m + 20% x $0 =
$800,000

Suppose that the following are true:

 If the CEO exerts the high effort, Cool Tiles has an 80% chance of earning a profit of $1
million and a 20% chance of earning zero profit. If she exerts low effort, Cool tiles has a 50%
of earning $1 million and a 50% of earning zero. (These figures are calculated before
subtracting the CEO salary.)

 The CEO values the extra time and energy to exert high effort at $120,000. If she were to
leave Cool Tiles, she could work for another company, exerting low effort, for a salary of
$200,000.

 The CEO is “risk averse”, meaning that she prefers to receive a fixed salary to an “incentive
scheme” that ties her pay to something uncertain, like company profits. She values the
certainty of a fixed salary at $50,000. (So, for example, she would value a 50/50 chance of
receiving $250,000 or $0 at 50% x $250,000 + 50% x $0 – $50,000 = $125,000 + $0 – $50,000
= $70,000.)

Questions

A. Suppose that the shareholders can observe the CEO’s effort. In this case they can pay her based on
the effort she exerts. What would be the company’s expected profit (net of CEO salary) if they pay
the CEO $325,000, conditional upon her exerting high effort? What if, instead, they offered her
$200,000, unconditional on her effort?

B. Now suppose that the CEO’s effort is unobservable. If the company pays her a fixed salary of
$325,000, what would be its expected profit? What if it pays her $200,000?

C. Instead, suppose the company offers the CEO an incentive package in which she will be paid
$455,000 if the company earns a high profit and $50,000 if the company earns a low profit. Would
she accept this package (compared to getting another job)? Would she exert high effort?
D. What is the company’s expected profit under the incentive scheme?

E.Instead of the incentive scheme, suppose the company pays the CEO a bonus for meeting a target
number of roof tiles sold. What is a potential problem with this policy?

Answer

A. First, we must make sure that the CEO will accept the high-effort contract. The costs to her of
taking the job and exerting high effort are $200,000 (her opportunity cost) + $120,000 (the cost of
high effort) = $320,000. So, she will accept the contract and exert high effort.
In this case, the company’s overall expected profit is
80% x $1m + 20% x $0 – $325,00 = $475,000

If they offer her $200,000 instead, she will accept the contract (which just covers her opportunity
cost) and exert low effort. In this case, company’s overall expected profit is

50% x $1m + 50% x $0 – $200,00 = $300,000

So, it is in the shareholders’ interest to pay the CEO to exert high effort.

B. Because the company cannot observe her effort, the CEO will exert low effort, and the company’s
expected profit is

50% x $1m + 50% x $0 – $325,00 = $175,000

If they pay her $200,000, the outcome is the same as in part A, with expected profit equal to
$300,000, because she will exert low effort in either case.

C. To see if she would accept the package, we must calculate her expected salary. To start, let’s
suppose she exerts high effort, then her expected salary is

80% x $455,00 + 20% x $50,000 = $374,00.

This is greater than her costs, which are equal to $200k (opportunity cost) + $120k (cost of high
effort) + $50k (cost of accepting an uncertain salary) = $370k. So, she will accept the contract, which
leaves her with a surplus of $4,000 ($374k – $300k).

Now, we must check whether she is at least as well off exerting high effort as low effort. If she exerts
low effort, her expected salary is

50% x $455,000 + 50% x $50,000 = $252,500.

This is also greater than her costs of accepting the job and exerting low effort, which are equal to
$200k (opportunity cost) + $50k (cost of accepting an uncertain salary) = $250k. But leaves her with a
surplus of $2,500, which is less than her surplus from exerting high effort. So, she will exert high
effort.

The following table summarises the calculations (numbers in thousands of $):

Expected Salary Costs Surplus

Low effort 50% x 455 + 50% x 50 = 252.5 200 + 50 = 250 2.5

D. Because the CEO will exert high effort, the company’s expected profit is

80% x ($1,000k – $455k) + 20% x ($0 – $50k) = $436k – $10k = $426k.

This is better than the expected profit when they pay the CEO a fixed salary ($300k) but not as good
as if effort were observable ($475k). Note that, even though her expected salary is higher with
unobservable effort, the CEO is also no better off because she must take on part of the risk of the
company by accepting a salary that depends on company profits.
The difference is lost economic surplus due to the private information of the CEO, which economists
refer to as “agency cost”. (See the video in Section 10.3 of the Week 10 ICL.)

E. Presumably, the company would offer this bonus as an incentive for the CEO to exert high effort in
marketing and sales of the company’s tiles. However, CEO may respond by taking actions that
increase sales at the expense of other objectives that are difficult to measure. For example, the
shareholders may not know what the profit-maximising price for the tiles is. In this case the CEO
could sell more tiles (and earn her bonus) by set a price below the profit-maximising price, leading to
lower profits for the company. (See the video in Section 10.3 of the Week 10 ICL.)