Consider a risk neutral employer and a risk neutral employee. The employee can e

Question

Consider a risk neutral employer and a risk neutral employee. The employee can either work hard or not. Let L for low effort or H for high effort correspond to its effort level. If the employee exercises low efforts, then it has an associated cost of 3 to him. But s/he generates profits for the employer of 8 with probability 1/2 and 0 with probability 1/2. If the employee exercises high efforts, then it has an associated cost of 4 to him. But s/he generates profits for the employer of 8 with probability 3/4 and 0 with probability 1/4. Assume that the employee maximizes his pay minus his costs and it has an outside opportunity of 0 (no effort no rewards). If the employer can only offer a take or leave it offer before observing the effort level: 1. Set up the problem the employee faces. 2. Set up the problem the employee faces. 3. Can the employer offer a wage to induce high efforts? 4. If the employee is willing to wait after the employer sees the outcome to get paid (i.e. a bonus scheme), would your answer change? If so, how? 5. If the employer can observe the effort level before he pays his employee, what should he do?

Explanation / Answer

1) for low effort gain from employer= (0.5*8+0.5*0)=4

for high effort gain = (0.75*8+0.25*0)=6

So the problem here is that more wages employer gives more are the chances that the employee will put High efforts which wll increase his gains

2) If Employee put high efforts the gain to him = Wage-4 to him

if he puts low effort the gain = Wage-3

so the employee will put low efforts as the low efforts maximizes his gain

3) The problem with employer is to get high efforts from the employee and the employee's Gain has direct relation with Wage which may seem constant in both the cases and so employee is bound to put in less efforts to maximize his gain , although the wage may rise the employee will not prform better since he will gain the same in both the cases

4)Yes, so in this case the bonus of atlease more than 1 unit will make the employee to work hard and maximize his gain since now the cost of putting high efforts will be obviated by bonuses so bonus of >1 unit will make the employee to put in more efforts.

5) In this case he should give more than 1 unit of bonus to those employees who are putting high efforts.

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