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Question 2:

The Sonjan company currently purchases health insurance for all of its 1,000 employees. The company is considering adopting a flexible plan whereby employees either can have $2,000 in cash or purchase an insurance policy (which currently costs $1,000). Do you see any potential problems with the new plan? Explain.   (Suggested time: 10 minutes)

Answer guide:

The plan represents an increase in payouts to employees. However, this increase in pay might be necessary to attract and retain qualified employees. The plan also gives the employees flexibility in choosing their own benefits. One potential problem with the plan, however, is adverse selection. The people who are least healthy are the most likely to purchase insurance. The insurance company will realize this incentive. Most likely, it will begin requiring medical exams for applicants. This action will increase the costs of providing insurance to employees. The insurance company might also increase prices because it realizes that it will have a less healthy pool to insure. A second problem with the plan is administrative costs. The company must incur costs to explain the plan to employees and operate a system that keeps track of each employee’s choice, etc.

Question 3:

Why may employees prefer a part of their compensation to be paid in kind such as in terms of fringe benefits? Discuss how firms can choose optimal combination of salary and fringe benefits in the hiring process of new employees.                                (Suggested time: 15 minutes)

Answer guide:  

Employees may prefer a part of their payments to be made in terms of fringe benefits because sometimes payment received in terms of fringe benefits may be beneficial for employees due to tax implications. Certain fringe benefits may not be subjected to income tax. For example, employees may prefer the employer to purchase health insurance policies for them instead of receiving cash salary to cover the cost of purchase of health insurances. This is because insurance premiums are not considered as income and are not taxed. However, salary and fringe benefits are not perfect substitutes and employees may or may not be indifferent between them. Also, sometimes it is better for the firms (employers) to purchase insurance or other items at a discounted rate.

Firms can choose optimal combination of salary and fringe benefits by choosing a combination of salary and fringe benefits that meets the employee’s reservation utility. This is shown in the figure below. As the figure indicates, the employee’s reservation utility is represented by the indifference curve U and the firm can hire using any compensation package along this indifference curve. At all points of the indifference curve U, the employee gets same utility with various combinations of salary and fringe benefits. The figure also shows the isocost curve that indicates that the firm’s value remains unaffected whether the firm pays the employee fringe benefit or salary of the equivalent amount. To maximise the firm’s value, a compensation package is chosen that meets the reservation utility of the employee at the lowest cost. This is the point of tangency (A) of the indifference curve U and the isocost line. The optimal combination of salary and fringe benefits is shown by S* and F*, respectively. Firm could choose other combinations along the line U but these are more expensive. Also, if the firm chooses less expensive combinations, these would not be able to meet the employee’s reservation utility.  

 

Question 4:

What are the key concerns for a firm about motivating its employees to do jobs requiring multitasking?

John works 20 hours per week at a mobile phone manufacturing company. His job consists of assembling the phones and checking the quality of the phones that he assembles. Suppose t₁ and t₂ denote the hours per week John devotes to produce the output and checking quality, respectively. John tries to maximise his compensation given by,

 

Where α’s are the weights that the compensation plan places on quantity and quality (incentive coefficients). If the incentive coefficients are equal, then how does John split his hours of work between assembling and checking of quality of the phones? (Suggested  time: 15 minutes)

Answer guide: 

Unlike the standard principal-agent model where firms only care about employees’ effort to work hard, in a multitasking job environment, managers and supervisors have to not only ensure that employees work hard but also, that the employees optimally allocate their time among the alternate tasks. The managers and supervisors, on behalf of the firm, need to motivate (incentivize) the employees to spent time on alternative tasks. In doing so, the firms need to consider the following,

Measurement errors: Firms need to consider whether performance/ activities or output can be measured accurately. For example, it may be difficult for a manufacturing firm that the drivers drive the company trucks carefully. The firm could define incentives to encourage careful driving.

Substitution across tasks: It is also important for the firms to realise that incentives for one task will tend to reduce performance of the employees on other tasks. Hence, firms need to be careful about providing strong incentives on one dimension (such as delivery time for an employee) only.

Risks: When risk is increased, then employees or independent contractors need to be compensated

John’s compensation plan is given by,

 

Where α’s are the weights that the compensation plan places on quantity and quality (incentive coefficients).

Given that John works for 20 hours per week, John’s compensation criterion can be rewritten as follows,

The above expression implies that the John is paid in response to how much s/he produces (the first term on the RHS) also an amount that reflect the quality of what s/he produces (second term on RHS).

John will choose t₁ to maximise compensation.

Taking the first derivative with respect to α₁ yields (FOCs):

 

 

 

When the incentive coefficients are equal, α₁ = α₂, then t₁ = 16 and t₂= 20-16= 4.

Hence, John spends 16 hours for assembling and 4 hours per week to check the quality of the phones.

Question 5

Consider a monopolist has two divisions: manufacturing and distribution.  The cost and demand structures faced by the monopolist are as follows,

            

Where MC, P and Q stand for marginal cost, price and quantity, respectively.

The fixed cost of the firm is zero. If information is perfect or costless, then calculate the optimal price, output and profit for this firm.

Now, assume information is asymmetric and the manufacturing division sets a transfer price (Pt). The manufacturing division has the monopoly power, and the decisions of the manufacturing division can’t be monitored since information is costly.  Calculate optimal transfer price, market price, profit reported by each division and firm profits. Explain your answer using appropriate diagrams. Suggested time: 20 minutes)

Answer Guide:

Given then fixed cost = 0, MC = 10 and P =210-10Q

 

MR = MC è 210 – 20 Q =10 è Q = 200/20 = 10

P=210 – 10(10) = 110   and   

 

 

Hence P =110, Q=10 and

Under asymmetric information, manufacturing division sets the transfer price (P_t)

 

Solve by backward induction

The distribution division faces demand curve given by

Distributor equals MR = MC where MC = Pt

 

 

This is the reaction function of the distribution division and the demand function faced by Manufacturing division.

 

 

 

 

 

Alternatively,

 

Alternatively

Hence, Pt =110;  P = 160       Q=5        

Total firm Profit with transfer pricing under Info Asyme = 500 +250 = 750

Compared to profit (with perfect info.) = 1000

Draw diagrams on your own. See lecture notes/ tute solution. And also Brickly et al pp. 553-555.

 

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