A executive can either slack (effort e = 0) or work hard (e = 1) on behalf of shareholders. If she slacks, the firm earns a gross return of 1,000 for sure. If she works hard, there is an even chance of the gross return being 10,000 or 80,000 . Her overall utility equals her utility from wage income (of the form w1/2, where w is the wage) minus the disutility of work (simply d), or in other words U = w1/2 d. If she slacks, she experiences no disutility of work (d = 0) but if she works hard, the disutility of work is d = 50 . Assume that U = 0 in her next best available job. What is the optimal wage contract that shareholders would offer if they can observe the effort of the executive?
a. A flat wage w = 0 and no requirement to work hard.
b. A flat wage w = 50 and a requirement to work hard.
c. A flat wage w = 2,500 and a requirement to work hard.
d. A share of 50 of the profits and a requirement to work hard.
Question 2
Return to the ready-to-eat cereal example from the previous question. Now assume that there is only one kind of cereal, so the manufacturer cannot distinguish between types of consumer (adults vs. children, of which suppose there are equal numbers in the market). What is the optimal menu of cereal boxes?
a. a 3 ounce box (which adults will buy) sold for 48 cents; a 4 ounce box (which children will buy) sold for 1.12.
b. a 3 ounce box (which adults will buy) sold for 48 cents; a 4 ounce box (which children will buy) sold for 64 cents.
c. a 2 ounce box (which adults will buy) sold for 36 cents; a 4 ounce box (which children will buy) sold for 76 cents.
d. No menu; the manufacturer is better off just selling a 5 ounce box for 1.12, which is only purchased by children.
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