MGT100 Professor Reshef & Professor Wu
Olin Business School Washington University in St. Louis
Problem Set # 5
1. A salesperson can choose either high effort or low effort selling a water bottle. If she works hard, she
can successfully sell the bottle with 100% probability, at an effort cost of 10. If she does not work, she can
sell it with probability one half, at a lower effort cost of 0. Assume the salesperson does not have any outside
options. The salesperson’s effort is not observable. Her compensation scheme is as follows: she receives a
wage of 15 if she successfully makes the sales and receives a wage of 0 if unsuccessful. The salesperson’s
utility is her wage minus cost of efforts.
a. What is the salesperson’s welfare if she decides to work hard?
b. What is the salesperson’s welfare if she does not work?
c. Under this compensation scheme, will the salesperson work hard or not work?
A manager oversees the performance of the salesperson and designs the compensation scheme. If the bottle
is successfully sold, the manager receives a utility of 40. If the sale is unsuccessful, the manager receives a
utility of 30. The manager’s total payoff is her utility from sales minus the wage paid to the salesperson.
d. Suppose the manager now considers two compensation schemes. One is the above scheme: pay the
salesperson 15 if successful and 0 otherwise (this is a high-powered incentive scheme). The second scheme
is to pay the salesperson 5 no matter what (a low-powered incentive scheme). Which scheme should the
manager choose?
e. Briefly explain why fixed salary works better than pay for performance in this scenario.
(Moral Hazard) 2. A MGT100 TA can provide two kinds of efforts. One leads to increased TA session
attendance (𝑒 ) while the other involves giving more lecture reviews / office hours (𝑒 ). Her cost function
of providing these two efforts is as follows:
𝑐(𝑒 , 𝑒 )= 𝑒 + 𝑒 − 𝑒 𝑒
She is paid with salary s, and offered bonus 𝑏 for every unit of 𝑒 she puts in encouraging all students
attending her session on a regular basis. Such attendance rate may be achieved with probability 𝑒 . She is
also offered bonus 𝑏 for every unit of 𝑒 she puts in for providing lecture reviews.
a. What are the TA’s marginal costs of 𝑒 and 𝑒 ? What happened to the marginal cost of 𝑒 when she
works on increasing the attendance rate (increasing 𝑒 ) by singing Gangnam Style in the beginning of each
session? What is the relationship between the two efforts?
b. Given the incentive scheme, what are the TA’s provisions of 𝑒 and 𝑒 ? Express them in terms of 𝑏 and
𝑏 . What happened to 𝑒 when you increase 𝑏 ? What is the relationship between the two incentive powers?
c. The professor, Hugh, who is the one paying the TA, cares about both attendance and the provision of
lecture reviews. How should he set up 𝑏 and 𝑏 ? No calculation is needed. Just explain intuitively.
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ection 02
Ubsection F
a welfare pay effort 15 10 5
b welfare 115 01
110 01 7.5
C B C the salesperson earns more welfare from not working hard they'llchoose
that option
a 1stscheme 11401511,13001 27.5 no effort
2ndscheme 4140 51 1,13051 30 no effort
Choose 2ndscheme b c the manager payoff is higher
e A fixed salarymaximizes total payoff b c the employee willalways put in low effort
a Mce b fe
Moe c
fe
As Mce decreases e increases b c the efforts are complements b c kis negative
b MBe b e b c
yes he
MBE b e
fe bz e fe
Increasing b causes e to decrease Thus when you gain more benefit from the
secondtask the first taskrequires lesseffort
C B C the tasks are complements Hugh should use highpoweredincentives for one
of the tasks Doing this
