Last year Ted paid the manager of his store a fixed salary of $65,000 and the st
ID: 1210632 • Letter: L
Question
Last year Ted paid the manager of his store a fixed salary of $65,000 and the store made $120,000 in profits (not counting the payment to the manager). This year Ted decided to change the incentive offered to his manager to $30,000 plus 15% of the store’s profits. The store is doing much better and Ted predicts that this year profits will be $280,000 (again, not counting the payment to the manager).
Assuming the change in compensation is the reason the store is doing better, how much more money will Ted make because of the change?
Discuss the problem of asymmetric information and incentives between the owner and the manager.
Does a change in contract resolve the problem?
Explanation / Answer
The incentive offered to the manager = $ 30,000 + 0.15 X $ 280,000
The incentive offered to the manager = $ 72,000
Before the change in compensation the profit made by Ted after taking into account the salary paid to manager = $ 55,000 ($ 120,000- $ 65,000)
After the change in compensation , the profit made by Ted after taking into account the salary paid to manager = $ 208,000 ( $ 280,000 - $ 72,000)
Because of the change Ted will make more = $153,000 ( $ 208,000 - $ 55,000)
Problem of asymmetric information arises when one party possesses knowledge needed for rational decision making that another party lacks . In this case the manager is lacking the information about how much profit Ted is making and therefore the manager faces problem of asymmetric information .
A change in contract that provides full information to the manager regarding the profits made by Ted can solve the problem.
Because of the change , Ted will make =
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