Question

A manufacturing firm employs a CEO that experiences a 3/4 probability of successfully generating $10 million in revenue if she works hard. She only generates $1 million in revenue for her company with a probability of 1/4 if she works hard and loses the case. Alternatively, if this CEO does not work hard she only has a 1/4 probability of successfully generating $10 million in revenue. She experiences a 3/4 probability of only generating $1 million if she does not work hard. This CEO experiences costs of $250,000 if she works hard and costs of $150,000 if she does not. While she knows if she’s working hard, her company can not determine whether she is working hard when she is successful or when she fails. a.) If the manufacturing company pays this CEO $150,000 above the market rate of $400,000 whether she succeeds or fails, will she have incentive to work hard? Explain. b.) What is the CEO’s net earnings at this pay level? c.) What is the company's expected profit for this situation?

Answer 1

a) If the CEO works hard she will have to experience 2,50,000$ of cost and If she doesn't she will experince 1,50,000$ of cost. Now the Profit of the frim doesn't have any relation with the CEO's incentives part and hence the CEO would always choose not to work hard as the cost associated with working not hard is just 1,50,000$ which is less than 2,50,000$ cost if she works hard. So unless some prportion of firm's profit is to be given to the CEO as incentive/salary the CEO will never work hard as she always wants to maximize the pay.

b) CEO's net earning= Salary - Cost

and in the above condition stated in case a the net earning of the CEO=400,000+150,000-150,000 = 400,000$

c) As the CEO is not going to work hard the Firm's exp profit is = 1/4*10 + 3/4*1 = 3.25Mn$

As the profit when ceo doen't works hard has 1/4 th of prob of hitting 10 and 3/4th of prob of hitting 1

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