Self Test

Incentive Pay

Shimadzu, a manufacturer of precise scientific instruments, relies heavily on the efforts of its local salespeople. Selling an instrument requires either luck, high effort, or some combination of the two. A salesperson who chooses to work hard has a 40 percent chance of selling an instrument in a given year while a salesperson who chooses to slack off has a 20 percent chance. Practically no one manages to sell more than one instrument in a single year. Contracts for salespeople are designed on a year-by-year basis. Sales staff members do not mind risk; they choose employers based only on expected wage and the disutility of effort. Disutility of effort is equivalent to $20,000 per year if they work hard and $0 if they slack off. Even if a salesperson slacks off, he or she requires an average salary of at least $50,000 not to seek alternate employment. Thus, the relevant data are:

Effort Level	Chance of success	Cost
High Effort	0.4	20,000 + 50,000
Slack Effort	0.2	50,000

Question 1.

What is the optimal compensation scheme if Shimadzu only wants slack effort?

	f = 20,000, b = 0
	f = 50,000, b = 0
	f = 70,000, b = 0
	f = 125,000, b = 0
	f = 250,000, b = 0
	f = 0, b = 50,000
	f = 0, b = 70,000
	f = 0, b = 100,000
	f = 0, b = 125,000

Question 2.

What range of bonuses will achieve high effort?

	b ≥ 20,000
	b ≥ 50,000
	b ≥ 70,000
	b ≥ 100,000
	b ≥ 125,000
	b ≥ 250,000

Question 3.

What is the optimal compensation scheme if Shimadzu wants high effort?

	b = 20,000, f = 50,000
	b = 50,000, f = 50,000
	b = 50,000, f = 250,000
	b = 100,000, f = -50,000
	b = 100,000, f = 30,000
	b = 250,000, f = -30,000

Question 4.

If Shimadzu receives a profit of $300,000 from each sale, what is its expected profit from inducing slack effort?

	10,000
	50,000
	100,000
	180,000
	250,000

Question 5.

If Shimadzu receives a profit of $300,000 from each sale, what is its expected profit from inducing high effort?

	10,000
	50,000
	100,000
	180,000
	250,000

A firm is trying to entice several of its managers to put in high effort by providing a bonus if their divisions' profits grow by 10 percent. Each manager has a cost of both routine and high effort, and estimates the chance of achieving the profit required for a bonus for each effort level. For each manager below, calculate the minimum bonus required to entice high effort.

Question 6.

Manager A

Effort Level	Chance of success	Cost of effort
High Effort	0.6	300,000
Routine Effort	0.5	260,000