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Economics 151A Professor David Neumark Problem Set 4 Due Thursday, December 4 1.

A worker has cost of effort function C(E) = E2/10, and a firm earns revenue E for each unit of effort expended by the worker. (Firms hire 1 worker.) Pay is set according to + E. ( is the commission rate.) a. What is the workers utility maximizing choice of E as a function of ? The worker will choose an effort level at which the marginal cost of effort is equal to the dP marginal benefit: MCE = MBE " dC = dE " E = ! " E* = 5! . (Let P here denote the dE 5 pay equation.) b. The firm chooses and to maximize profits subject to how the workers effort responds to these pay parameters, and the constraint that pay be greater than or equal to the cost of effort. What values of and maximize profits for the firm? The firms profit is total revenue minus total costs, or ! = E $ (" + # E ) . Then, the firms optimization problem is to maximize ! such that pay be greater than or equal to the cost of effort, or ! + " E #
E2 10

. The profit-maximizing firm will only consider the constraint at the


E2 10

equality, so we assume that ! + " E = maximize ! = E "


E2 10

. We can incorporate the constraint into the


E 5

optimization problem by substituting for ! + " E in the profit equation, so the firm now can . The first-order condition for this optimization is 1 !

= 0 " E* = 5 .

The firm, having found a profit maximizing level of effort, can ask the worker how high the commission must be to get 5 units of effort. From part (a), we know that E* = 5! , so the commission must be ! * = 1 . With this information, we can use the effort cost/pay constraint to find the fixed part of the pay rate: ! + " E =
E2 10 5 # ! + 1 $ 5 = 10 # ! * = %2.5 .
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c. Suppose a minimum wage law is passed that says workers must be paid a base wage of $1 before any commissions are paid (that is, must equal 1). Will the firm raise or lower its commission rate? Why? Do profits rise or fall? (You dont need to solve a complicated problem to figure out the answers to these questions.) No, the firm will not change its commission rate. The base wage does not enter the marginal cost function (i.e., it falls out when you take the derivative of the cost function with respect to effort), so the firms optimization problem yields the same commission rate. Profits must fall because the firm was previously maximizing profits. If we follow the same optimizing process in parts (a) and (b), we would still find that E* = 5! after the worker optimizes and that E* = 5 and ! * = 1 after the firm optimizes. Whereas profit was ! = E $ (" + # E ) = 5 $ ($2.5 + 5) = 2.5 when ! was unconstrained, profit becomes ! = E $ (" + # E ) = 5 $ (1 + 5) = $1 when ! is constrained to equal 1. (In this case, the firm will go out of business and not hire any workers, but changing the commission would have made no difference.)

2. A taxi company is considering two pay schemes for drivers. i. It rents cabs to drivers for $100 a day. The driver charges riders $2 per mile driven, which he keeps for himself. (Ignore the cost of gasoline.) (This is a 100% commission.) ii. Charge the driver no rent, and split the $2 per mile charge 50-50 with the driver. (This is a 50% commission.) In either case, the number of miles that passengers are driven is measured by the taxi meter, which is supposed to be turned on whenever a passenger is in the cab. a. Under the first plan, are there ways the cab driver can cheat the company to make more money for himself and less for the company? What about under the second plan? Under the first scheme, there is no way to cheat the company. Under the second scheme, the driver can underutilize the meter and collect fares or tips on the side for himself. Consider a customer who enters a cab knowing the citywide taxi fare is $2. If the driver under the commission-sharing plan offers to turn off the meter, but only charge $1.50 per mile, both driver and rider are better off. b. Under which plan is the driver likely to drive more hours? Explain. The driver is more likely to drive long hours under the rental scheme. Consider some nth hour of work. The driver will weigh the tradeoff between work and leisure. The marginal benefit of work is the fare, which is greater under the rental plan even if the driver under the commission-sharing plan is cheating. No matter what the marginal benefit of leisure is, the driver is more likely to work that last hour under the rental plan. c. Now consider a concrete example for part b. Suppose the driver is deciding whether to work the 12th hour of his shift. He expects to take in $10 in cab fare during that hour, and values that hour of leisure at $8. Will he work the 12th hour under plan i? Under plan ii? Under the first plan, he will definitely work because he keeps the entire fare. Under the second plan, he will work only if he is a very good cheater (i.e., can take home at least 80% of the fare by only reporting 3 of the 5 miles driven). d. Under plan i, does the taxi company care if the driver works the 12th hour? How can the taxi company adjust the pay scheme so that the driver continues to work the 12th hour but the company earns more? The company can increase the daily rental rate. If the company takes part of the commission, it alters the marginal benefit of working, lowering the likelihood that the driver works the 12th hour. By increasing only the daily rental rate, the company increases its revenues without changing driver behavior on the margin. 3. Now suppose there are two cab companies. Company A uses pay scheme i, and Company B uses pay scheme ii.

a. Suppose that drivers vary in productivity, measured as the number of miles they drive with passengers. Graph the compensation of a driver working for each company, as miles range from 0 to 200 miles per day.

b. How do workers of varying productivity sort among the two companies? Low-productivity (low daily mileage) drivers will prefer scheme (ii) with no upfront cost for driving. High-productivity drivers will prefer scheme (i) because they earn more with Company A after driving at least 100 miles. This is an example of adverse selection. Drivers know more about their own productivity than firms (i.e., there is an information asymmetry). The revenue of Company B is dependent on the productivity of its drivers, while the revenue of Company A is independent of the productivity of its drivers. Unfortunately, the incentive structure of Company A will attract the highly productive workers, making the selection adverse for Company B. c. If workers of different productivity all have the same cost of effort, how can Company A respond to this sorting to increase its profits? Company A can increase its daily rental rates. As mentioned in the previous problem, Company A will change the marginal incentives if it instead collected part of the commission. By increasing the rental rate, it ensures the positive sorting by productivity described is part (b), an increase in revenue, and thus an increase in profits. 4. The structure of prizes for Wimbledon are as follows for 2005 (in pounds, for men): 1st place: 2nd place: 3rd and 4th place (semi-final losers) 5th-8th place (quarter-final losers) etc. 630,000 315,000 157,500 81,900

The rights to the Wimbledon tennis tournament have been sold to a new company. The new organizers look at this prize structure. They correctly figure that the 1 st and 2nd place finishers won the same number of matches, of the same average level of difficulty, to get to the final, and that in the final the winner may have won by a very small margin, so that these two contestants probably played almost equally well throughout the entire tournament. As a consequence, they decide to reduce the first-place prize money to 350,000, to better reflect the difference in quality of play between the 1st and 2nd place finishers. a. What impact is this likely to have on the quality of play at Wimbledon in the final match? The marginal benefit of winning has been reduced from $315,000 to $35,000. Since the probability of winning depends on the effort of the player and effort is costly (e.g., players who play harder are more likely to get injured), then the quality of play in the last match should decrease so that the marginal benefit is equal to the marginal cost. b. What impact is this likely to have on the quality of play in the matches leading up to the final match? Part of the benefit of winning any one preliminary round of the tournament is the continued chance to play in the final round and winning. But since the benefit of winning has been reduced, so has the benefit from winning any preliminary round. Again, since effort is costly and the marginal benefits of winning have been reduced for each round, we would expect that the level of play in each round should be reduced from reducing the winning prize. c. As an alternative, they substantially reduce the prize difference between 1 st and 2nd place but keep the total prize amount for these two finishers (945,000) the same. How does this change your answers to parts a and b, if at all? Reducing the winners prize will result in a decrease in the marginal benefit from winning the final round and thus the marginal cost must also fall by reducing effort. This answers is identical to part a. However, whether or not the level of play is reduced throughout the tournament is ambiguous. If the players are truly evenly matched and thus have the same probability of winning the final match, then the value of making it to the final round remains the same and the level of play in the preliminary rounds will not be affected. However, if one player has a slight advantage over the others, that is, he is more likely to win the final round, then the marginal benefit of making it to the final round has been reduced for this player and thus he would lower the marginal cost of each round by lowering the level of effort. d. Dick and Jane are two Vice Presidents of a large corporation. Both have been with the corporation for many years, rising through the ranks. Both are highly productive and competent, the quality of their work is very similar, and each earns $1 million per year. When the President resigns, the Board of Directors decides that Jane is slightly more qualified. She is promoted to President, and her pay increases to $10 million. Why would pay be structured so that a worker who is slightly more productive is now paid 10 times as much? What is the relationship to the structure of prizes at Wimbledon? The marginal benefit of extra effort on the part of the Vice Presidents is a function of both the increased probability of winning and the value of the Presidents salary. But because both Vice Presidents are highly productive, an increase in effort will result in only a small increase in the probability of winning. As a result, the difference in pay between the President and Vice Presidents must be very large in order to elicit an increase in effort. The board is likely

interested in sorting the Vice Presidents between the one who is willing to put in the most effort and who is the most confident in their abilities and the tournaments design allowed the Vice Presidents to send such a signal to the board. This salary structure resembles the original Wimbledon prize structure described above. Just as the modified payoffs in the Wimbledon scenario lowered match quality through the tournament, this corporate pay structure will give employees at the corporation incentives to provide effort throughout the corporate hierarchy. The expected value of being promoted from manager to senior manager includes, even to some small extent, the benefit of one day being the president times the increased probability of being the president in the future.

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