Question

There are four levels of ability for workers: excellent, good, ok and bad.

Excellent workers produce goods worth $10000 and have outside options of $6000, good workers produce goods worth $8000 and have outside options worth $5000, ok workers produce goods worth $6000 and have outside options worth $4000 bad workers produce goods worth $4000 and have outside options worth $3000.

In the workforce, 10% are excellent, 30% are good, 50% are ok and 10% are bad.

Workers know their own ability, but firms cannot observe ability.

1. a) What is the profit maximizing wage firms should offer to workers?

2. b) Now firms are able to observe if a worker is bad or not, but not if he is ok, good or excellent. How do your answers to a) change if the firm can offer different wages to bad workers and other workers?

3. c) How much would firms pay at most for information that reveals each workers’ type?

Answer 1

a. Profit maximizing wage that firm should offer to workers should be greater than Outside options for Good category employees (5000) and less than the Output of OK category employees (6000). So profit maximizing wage should be between 5001 to 5500.

	Excellent	Good	Ok	Bad
Output	10000	8000	6000	4000
Outside Options	6000	5000	4000	3000
	10%	30%	50%	10%
Assuming 100 Employees, total Output is calculated as under:
Total Output	100000	240000	300000	40000	680000
					divide by 100
				Per Emp Output (Avg)	6800

b. Yes, the wages to identified bad workers should be decreased and should lead to corresponding increase for rest of workers. So profit maximising wage can be between 5500-6000 for good workers.

c. For each category type which is now revealed, the firm should pay higher than the outside options for retention and lower than the output for each category for profit maximization.