Managerial economics and business strategy 8th edition by baye and prince test bank

Managerial Economics & Business Strategy 8th edition by Michael R Baye, Jeffrey T Prince Test Bank Link full download: https://findtestbanks.com/download/managerial-economics-and-businessstrategy-8th-edition-by-baye-and-prince-test-bank/ Chapter 06 The Organization of the Firm Answer Key Multiple Choice Questions Often owners of firms who hire managers must install incentive or bonus plans to ensure that the: A company is financially secure B manager will work hard C manager will maintain employee morale D company will have positive economic profits AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem Which of the following forms of payment is NOT an incentive plan? A Commission plans for salesmen B Flat salary for a plant manager C Bonuses for managers that increase as profits increase D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Which of the following is NOT an incentive scheme to ensure that workers a good job? A Paying waitresses low wages, but allowing them to collect tips B Profit-sharing plans in large companies C Commission pay schedules for salesmen D Straight hourly wages for dock workers AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers Topic: The Manager-Worker Principal-Agent Problem Which of the following is NOT a means of avoiding opportunism? A Contracts B Spot exchange C Vertical integration D Long-term contracts AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement Long-term contracts become longer: A when specialized investment becomes more important B when the exchange environment is more complex C when spot markets work well D when marginal costs are declining AACSB: Analytic Blooms: Analyze Difficulty: Hard Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement A relationship-specific exchange occurs when: A a partnership is dissolved B specialized investments are important C a partnership is initiated D shareholders receive dividends AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement When relationship-specific exchange occurs in complex contractual environments, the best way to purchase inputs is through: A spot markets B vertical integration C short-term agency agreements D long-term contracts AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement A firm might choose to produce its own inputs if: A specialized investment is not important B long-term contracts are costly to write C the exchange environment is not complex D spot markets for the input exist AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement An agent hired by the owner of productive resources to control the production process is: A a laborer B a self-proprietor C an assembly worker D a firm manager AACSB: Reflective Thinking Blooms: Remember Difficulty: Easy Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem Spot exchange can be inefficient in the presence of: A opportunism B a complex contracting environment 10 C spot checks D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange; contract; or vertical integration Topic: Methods of Procuring Inputs 11 A negative side of long-term contracts is: A high transaction costs B a loss of flexibility C the continual need to renegotiate the contract D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange; contract; or vertical integration Topic: Methods of Procuring Inputs Spot markets are an efficient way for the firm to purchase inputs if: A opportunism is not a problem B suppliers engage in hold-up 12 C profit sharing is used to compensate managers D the supplier needs specialized investment to produce the input AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement The disadvantage of vertical integration is that: A relationship-specific exchange may cause hold-up B long-term contracts may be inflexible 13 C the principal-agent problem causes shirking D firms no longer specialize in what they best AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange; contract; or vertical integration Topic: Methods of Procuring Inputs In the absence of worker incentives: A everyone always gives maximum effort 14 B there is a natural tendency for workers to not give their maximum effort C managers have little or no control D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers Topic: The Manager-Worker Principal-Agent Problem A person who monitors the production process and evaluates the productivity of workers is: A a manager B an employee 15 C a shareholder D a self-proprietor AACSB: Reflective Thinking Blooms: Remember Difficulty: Easy Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers Topic: The Manager-Worker Principal-Agent Problem A drawback of separating ownership from control by creating a firm is: A the losses of specialization 16 B increased transaction costs C the principal-agent problem D synergies of team production AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem Shirking can take the form of: A long lunch hours B sleeping at work 17 C leaving work early D All of the statements associated with this question are correct AACSB: Reflective Thinking Blooms: Remember Difficulty: Easy Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers Topic: The Manager-Worker Principal-Agent Problem Which of the following payment plans does NOT give an incentive to a manager to stop shirking? A Flat salary with additional pay based on profits of the firm 18 B Pay schedule based solely on profits earned by the firm C Flat salary regardless of firm profits D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers The most likely effect of reducing performance-based rewards for the CEOs of corporations would be: A an increase in profits 19 B a drop in revenues C a drop in profits D an increase in the value of the corporation AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in millions) = $400 How much will this CEO be compensated? A $812,431 20 B $43,400 C $559,432 D $512,000 AACSB: Analytic Blooms: Apply Difficulty: Easy Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in millions) = $400 What percentage of the CEO’s total earnings are tied to profits of the firm? 21 A 8.2 percent B 10.9 percent C 7.8 percent D 5.1 percent AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem An incentive for managers to maximize profits is: A reputation B performance bonuses 22 C takeovers D All of the statements associated with this question are correct AACSB: Reflective Thinking Blooms: Remember Difficulty: Easy Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers A manager who tries to enhance worker effort by tying workers’ compensation to the profitability of the firm is using: A spot checks 23 B revenue sharing C profit sharing D piece rates AACSB: Reflective Thinking Blooms: Remember Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem A payment plan that induces better worker effort by linking compensation to revenues of the firm is known as: A revenue sharing 24 B profit sharing C piece rate sharing D spot checking AACSB: Reflective Thinking Blooms: Remember Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem An example of a job that usually involves a revenue-sharing plan would be: A waiters and waitresses B car salesman 25 C insurance agents D All of the statements associated with this question are correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem A negative side of a revenue-sharing plan is that it: A does not induce hard or better work 26 B can be costly if revenues are low C gives no incentive for workers to minimize costs AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem Time clocks are typically a solution to the: A manager-consumer, principal-agent problem B manager-owner, principal-agent problem 121 C consumer-worker, principal-agent problem D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem Spot checks are typically a solution to the: A manager-consumer, principal-agent problem 122 B manager-worker, principal-agent problem C consumer-worker, principal-agent problem D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 123 The threat of a corporate takeover is an _ incentive that helps to mitigate the _ principal-agent problem A internal; manager-worker B internal; manager-consumer C external; owner-manager D external; owner-consumer AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers Managerial reputation is an _ incentive that helps to mitigate the _ principalagent problem A internal; manager-worker 124 B internal; manager-consumer C external; owner-manager D external; owner-consumer AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers A decrease in the marginal benefit arising from a specialized investment will cause the optimal contract length to: A increase 125 B decrease C remain constant D either increase or decrease AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement An increase in the marginal cost arising from a more complex specialized investment environment will cause the optimal contract length to: A increase 126 B decrease C remain constant D either increase or decrease AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement A decrease in the marginal cost arising from a less complex specialized investment environment will cause the optimal contract length to: A increase 127 B decrease C remain constant D either increase or decrease AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement Which of the following is NOT a solution to the manager-worker principal-agent problem? A Revenue sharing 128 B Profit sharing C Time clocks and spot checks D The threat of a takeover AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem Which of the following is NOT a type of specialized investment? A Site specificity B Physical-asset specificity 129 C Human capital D All of the statements associated with this question are types of specialized investments AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly bargaining; underinvestment; and/or a “hold-up problem.” Topic: Transaction Costs Long-term contracts become shorter: A when specialized investment becomes less important B when the exchange environment is less complex 130 C when spot markets work poorly D when marginal costs are increasing AACSB: Analytic Blooms: Analyze Difficulty: Hard Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement An increase in the marginal cost arising from a more complex specialized investment environment will cause the optimal contract length to: A increase 131 B decrease C remain constant D either increase or decrease AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement An increase in the marginal benefit arising from a specialized investment will cause the optimal contract length to: A increase 132 B decrease C remain constant D either increase or decrease AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement Suppose a firm manager has a base salary of $175,000 and earns 0.5 percent of all profits Determine the manager’s income if revenues are $10,000,000 and profits are $5,000,000 A $150,000 133 B $200,000 C $225,000 D $300,000 AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose a firm manager has a base salary of $50,000 and earns 2.5 percent of all sales Determine the manager’s income if revenues are $20,000,000 and profits are $5,000,000 A $50,000 134 B $175,000 C $550,000 D $700,000 AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose a firm manager has a base salary of $85,000 and earns 0.5 percent of all sales Determine the manager’s income if revenues are $2,000,000 and profits are $500,000 A $50,000 135 B $87,500 C $95,000 D $170,000 AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in millions) = $500 What percentage of the CEO’s total earnings is tied to profits of the firm? A 1.5 percent 136 B 7.9 percent C 10.6 percent D 43.4 percent AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total compensation of the CEO, π = company profits (in millions) = $400, and S = sales (in millions) = $700 What percentage of the CEO’s total earnings is tied to profits of the firm? A 2.0 percent 137 B 13.5 percent C 19.6 percent D 31.4 percent AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem Suppose compensation is given by W = 100,000 + 157 π + 12S, where W = total compensation of the CEO, π = company profits (in millions) = $340, and S = sales (in millions) = $700 What percentage of the CEO’s total earnings is tied to sales of the firm? A 5.2 percent 138 B 13.5 percent C 19.6 percent D 33.0 percent AACSB: Analytic Blooms: Apply Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Managerial Compensation and the Principal-Agent Problem By instituting performance-based rewards to CEOs the profits of firms will: A rise B fall 139 C remain constant D None of the statements is correct AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers Topic: Forces that Discipline Managers Essay Questions 140 Determine whether the following transactions involve spot exchange, contracts, or vertical integration a A major oil company refines gasoline from crude oil produced by oil wells that it owns b Transcontinental, an interstate natural-gas pipeline, has a legal obligation to purchase a specified amount of gas per week from a well owned by Fred Smith in Enid, Oklahoma c A cabinetmaker purchases a dozen wood screws from the local hardware store d An electric utility purchases coal from an underground mine (a) Vertical integration; (b) contract; (c) spot exchange; (d) spot exchange or contract AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange; contract; or vertical integration Topic: Methods of Procuring Inputs 141 In general, automobile manufacturers produce their own engines but purchase tires from independent suppliers Why? Engine manufacturing involves specific investments; by vertically integrating, the potential for opportunism is reduced Tires are more uniform and can usually be purchased by spot exchange AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement 142 Which of the following transactions are likely to result in relationship-specific exchange? a Purchasing gasoline for the company car b Hiring an employee to operate a machine that only your company uses c Buying napkins for the company snack bar d Purchasing coal for the factory furnace e Buying electricity Certainly b, and in some instances, d AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement Explain how each of the following affects the optimal method of acquiring an input a A complex contracting environment b A specialized investment c Opportunism d Bargaining costs e The costs of bureaucracy f Gains from specialization 143 a Makes contracts a less attractive form of input acquisition b Makes spot exchange problematic, due to opportunism c Leads to more detailed contracts or vertical integration d Leads to longer contracts, or in extreme instances, vertical integration e Reduces the gains to vertical integration and lead firms to use contracts or spot exchange to acquire inputs f Reduces the benefits of vertical integration AACSB: Reflective Thinking Blooms: Understand Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement 144 Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound hamburgers in a given week To meet that demand, Jiffyburger needs 2,000 pounds of ground beef delivered to its premises every Monday morning by 8:00 A.M sharp If you were the manager of a Jiffyburger franchise, how would you acquire the ground beef? Explain I would use a contract, since this would decrease the problems of opportunism while still allowing for specialization in production AACSB: Analytic Blooms: Evaluate Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement Explain why people in the following occupations are compensated as they are a Insurance agents b Football players c Authors d CEOs of major corporations e Food servers 145 a Insurance agents are usually compensated by a fixed base payment and a commission, which is positively related to the amount of business brought to the company Without the variable part of salary, insurance agents have little incentive to find clients b Football players are usually compensated by a fixed payment, along with incentives tied to performance for reasons similar to the insurance agent example c Authors typically receive royalties, which are revenue-sharing plans whereby the author receives a fraction of the revenues generated by the book This compensation scheme provides the author an incentive to write a high-quality book in order to generate lots of sales for the firm, and thus lots of royalty income for the author d A CEO of a major corporation is usually compensated by a fixed payment plus a variable bonus positively related to the amount of profits the corporation made Without the variable part of the payment, the CEO will not put forth as much effort as desired by the principal e Waiters and waitresses are usually paid a small fixed payment by restaurants The majority of their pay is derived from tips, since customers can monitor their servers while the restaurant manager cannot AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers Topic: Managerial Compensation and the Principal-Agent Problem Topic: The Manager-Worker Principal-Agent Problem A manager derives satisfaction from income and leisure on the job (shirking) a If the manager is paid a fixed salary of $100,000, how much leisure will she consume on the job during an eight-hour day? Explain b When the manager is given a salary of $100,000 plus 10 percent of the firm’s profits, she chooses to spend six hours managing and two hours consuming leisure Salary and bonus total $120,000 Does the manager necessarily prefer this situation to the situation in part (a)? 146 a She will consume the whole eight hours as leisure because working (putting forth effort) causes dissatisfaction to the manager Hence the manager will shirk if there is no punishment for doing so b The manager does prefer this situation to the situation in (a) There are two consumption bundles now: (1) $100,000 salary plus eight hours of leisure a day, and (2) $120,000 salary plus two hours of leisure a day Since the original choice of eight hours shirking and $100,000 is still available, the fact that she chose to work two hours reveals that she prefers the second pay scheme AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem 147 Is it necessarily in the best interests of shareholders for management to ensure that there is absolutely no shirking in the workplace? Explain Ensuring absolutely no shirking in the workplace implies very high monitoring costs There is a trade-off for shareholders between increasing productivity by reducing shirking and reducing the monitoring costs The manager should reduce shirking to the point where the marginal benefit from reducing shirking equals the marginal cost of reducing shirking AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem Discuss the benefits and costs of the following methods of monitoring worker performance: a Hidden video cameras in the workplace b Time clocks c Paying workers based on the output they produce 148 a The benefits are that it may be effective The problem is that it affects the morale of the workers Moreover, extra employees are required to watch the video b The major benefit of using time clocks is that they verify that workers show up to work However, they not provide any incentive to work once the workers are at the workplace c The benefits are that the manager can know the performance of individuals The costs are that it may be costly to so, and when the output is completed by teamwork or quality is hard to evaluate, it is difficult to know an individual worker’s performance AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 149 According to Industry Week, a shoe manufacturer recently had a production run that resulted in 100,000 pairs of defective shoes Workers on the production line knew the shoes were defective as they were being produced, but did nothing to fix the problem Do you think a profit-sharing plan for workers would mitigate future problems? Explain Clearly a profit-sharing reward scheme would have provided workers with an incentive to stop production The bottom line is that if managers want workers to produce quality products, they must structure rewards that promote that goal AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 150 College Retirement Equities Fund (CREF) is a pension fund that has billions of dollars invested in the stock market Fund participants recently voted on a proposal that would have placed strict limits on the amount of compensation paid to CREF executives Why you think 75 percent of the participants voted against the proposal? To the extent that the compensation paid to CREF executives is performance-based, executives receive large payments only if they are successful in increasing the net asset value of CREF funds Capping compensation would thus reduce the executives’ incentive to maximize the value of CREF funds, thereby reducing the overall return to the fund participants AACSB: Analytic Blooms: Evaluate Difficulty: Medium Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem 151 Suppose a principal knew with certainty the level of profits that would result if an agent put forth maximum effort a Would there be a principal-agent problem? b Devise two incentive contracts that would induce the manager to put forth maximum effort in this instance a There would not be a principal-agent problem if the principal could devise a contract such that the agent has no incentive to shirk b Incentive Contract 1: Pay the manager a percentage of profits, provided profits are maximal Otherwise, pay nothing to the manager Incentive Contract 2: The manager is paid a fixed salary if the profit reaches the maximal profit; the manager is paid nothing otherwise AACSB: Analytic Blooms: Create Difficulty: Hard Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent Problem 152 Dallas-based Southwest Airlines recently announced a 10-year contract that gives pilots a greater opportunity to share in the profits of the airline According to the terms of the contract, the pilots will receive options to buy 14 million shares of the firm’s stock over the next 10 years What impact you think this new contract will have on Southwest Airlines? The contract provides pilots an incentive to take actions that will enhance Southwest Air’s profits Pilots will thus be more likely to strive for on-time departures, smooth flights, and to be courteous to passengers AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 153 Art-R-Us makes hand-painted art reproductions The owner-manager wishes to hire another artist, and is considering paying a fixed wage plus either (1) a share of the profits from each painting sold or (2) a fixed payment for each piece produced Which plan would you choose if you were the owner? Explain A share of the profits from each painting sold Unlike a piece rate, this would provide the artist a greater incentive to produce high-quality reproductions AACSB: Analytic Blooms: Evaluate Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 154 In a 1998 press release, Boeing Commercial Airplane Group (BCAG) announced that it was signing a 10-year contract with distributor Thyssen Inc., a distributor of raw aluminum, valued at approximately $300 million The contract reflected Boeing’s effort to reduce costs and production bottlenecks resulting from supply shortages The contract specified prices and guaranteed quantities of raw aluminum to be delivered to BCAG’s suppliers If you were the production manager at BCAG, how would you justify the long-term nature of the contact with Thyssen Inc.? A contract permits it to avoid the hold-up problem in the future, but the trade-off is the uncertainty of the future economic environment AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement 155 As a manager of the WeDoWell Corporation, you have negotiated with several vendors and are on the verge of signing an eight-year contract with Bolts Enterprises Under the contract, they would ship to you 2,000 titanium bolts per month at a price of $1,000 per bolt Your assistant has just brought you an article from a trade publication that indicates another company has developed a new technology that reduces the cost of producing the titanium bolts How would this information affect the optimal length of your contract with Bolts Enterprises? Explain The reduction in another supplier’s cost of producing titanium bolts reduces WeDoWell’s marginal benefit of contracting Therefore, the eight-year contract it has been negotiating is too long; the optimal contract length is now less than eight years AACSB: Analytic Blooms: Analyze Difficulty: Medium Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs Topic: Optimal Input Procurement 156 At the recent shareholders’ meeting, the CEO of a small bank proposed a plan to offer each of its employees 250 incentive options for Class A common stock The key provisions of the plan are that employees must exercise the options between January 2014 and December 2019, and if an employee terminates his or her employment with the bank (or is terminated), the options are no longer exercisable One shareholder feverishly objected to the plan, claiming that such a move would dilute the value of the outstanding shares As CEO, how would you defend the stock option plan to the shareholders? The first important point to make with the shareholders is that this incentive plan is designed to maximize shareholder value This is achieved by giving employees an incentive to stay with the company longer, thereby reducing costly employee turnovers and increasing the company’s profitability Also, by using the stock options as an incentive plan, employees will want to find ways to work more productively and make the company more profitable The benefits to the shareholders and the employees will be a higher stock price AACSB: Analytic Blooms: Evaluate Difficulty: Hard Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem 157 You are the manager of Door-to-Door Vacuum Cleaners, Inc Each salesperson is paid a base salary plus a percentage of the revenues she or he generates In addition, each salesperson drives his or her car to and from each sales call and is reimbursed $0.40 per mile driven On average, each salesperson drives about 150 miles per day and 240 days per year As manager of Door-to-Door, how might you restructure the compensation of your sales force to enhance your profits? Are there any potential disadvantages of your plan? Explain The manager might pay a salesperson a base salary plus a percentage of the profits This plan would penalize salespersons, to some extent, for excessive mileage AACSB: Analytic Blooms: Evaluate Difficulty: Medium Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace Topic: The Manager-Worker Principal-Agent Problem ... owners and managers Topic: Managerial Compensation and the Principal-Agent Problem Principal-agent problems NOT arise between: A stockholders and managers B managers and workers 50 C stockholders and. .. Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial Compensation and the Principal-Agent... workers and consumers AACSB: Reflective Thinking Blooms: Understand Difficulty: Easy Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers Topic: Managerial