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TOPICS IN DEVELOPMENT ECONOMICS

ECON 30451

Tutorial 1

Question 1

An entrepreneur has hired an employee to undertake an independent project. If the project fails, it will lose 20k. If it succeeds, the project will earn 100k. The employee can choose to either work or shirk. If he shirks, the project fails for sure. If he works, the project succeeds with probability 50% and fails with probability 50%.

The cost of effort for the employee is equivalent to 10k. The entrepreneur is choosing whether to pay the employee a flat salary of 20k, or a performance plan under which the employee earns 0 if the project fails and 40k if the project succeeds. The entrepreneur cannot monitor the level of effort that the employee puts in, however he can clearly observe if the project has failed or succeeded.

a) Explain why this is a principal-agent problem;

b) Suppose that the entrepreneur is paying the flat salary, show that the entrepreneur would prefer the employee to work rather than to shirk;

c) Will the employee work or shirk if he is paid a flat salary?

d) Suppose that the entrepreneur is paying a performance plan, will the employee work or shirk?

e) Given how the employee responds to the performance plan incentives (your answer to d)), does the entrepreneur prefer the performance plan or a flat salary?

f) Would your answer be different if the flat salary was lower, say equal to 0?