Consider a managerial effort example similar to the one
in Section 5. The value of a successful project is $420,000; the probabilities
of success are 12 with good supervision and 14 without. The manager is
risk neutral, not risk averse as in the text, so his expected utility equals
his expected income minus his disutility of effort. He can get other jobs
paying $90,000, and his disutility for exerting the extra effort for good
supervision on your project is $100,000.
(a) Show that inducing high effort would require the firm
to offer a compensation scheme with a negative base salary; that is, if the
project fails, the manager pays the firm an amount stipulated in the scheme.
(b) How might a negative base salary be implemented in
(c) Show that if a negative base salary is not feasible,
then the firm does better to settle for the low-pay, low-effort situation.