Question

problem 06-06 (algo)

describe how a manager who derives satisfaction from both income and shirking allocates a 10-hour day between these activities when paid an annual, fixed salary of $130,000.

time spent working: hours
time spent shirking: hours

when this same manager is given an annual, fixed salary of $130,000 and 4 percent of the firms profits-amounting to a total salary of $160,000 per year-the manager chooses to work 7 hours and shirks for 3 hours. given this information, which of the compensation schemes does the manager prefer?

o the scheme with only a fixed payment of $130,000.
o the manager is indifferent between the two payment schemes.
o the scheme with fixed payment of $130,000 and a percentage of profits.

Explanation:

Analyze fixed salary incentives

Under a fixed annual salary of \$130,000, the manager's income is completely independent of the amount of effort or time spent working. Since the manager derives satisfaction (utility) from both income and shirking, and working does not increase income, the manager will maximize utility by maximizing shirking. Out of a 10-hour day, the manager will allocate all available hours to shirking.

Determine time allocation

Since the manager maximizes shirking under a fixed salary:

• Time spent working: 0 hours
• Time spent shirking: 10 hours

Evaluate compensation schemes

Under the second scheme, the manager receives a fixed salary plus a share of the profits, resulting in a total income of \$160,000 when working 7 hours and shirking 3 hours.

To determine preference, we compare the utility of the two outcomes:

1. Under the first scheme, the manager's bundle is: Income = \$130,000, Shirking = 10 hours.
2. Under the second scheme, the manager's bundle is: Income = \$160,000, Shirking = 3 hours.

Since the manager voluntarily chose the bundle (Income = \$160,000, Shirking = 3 hours) when faced with the profit-sharing incentive scheme, this choice must yield a higher utility than any other affordable bundle under that scheme. Furthermore, because the second scheme offers a significantly higher income (\$160,000 vs \$130,000) which compensates for the reduction in shirking, and is designed to align the manager's interests with the firm's profits, the manager prefers the profit-sharing compensation scheme.

Select the preferred option

The manager prefers the scheme with a fixed payment of \$130,000 and a percentage of profits.

Answer:

Question 1

Time spent working: <blank>0</blank> hours

Question 2

Time spent shirking: <blank>10</blank> hours

Question 3

• The scheme with only a fixed payment of $130,000.
• The manager is indifferent between the two payment schemes.
• The scheme with fixed payment of $130,000 and a percentage of profits. (Correct answer)