Use the following example to review the basic incentive problem in the owner/ employee conflict. Assume perfect contracting possibilities. Chef Tom Malone is the key employee for FancyFoods. His utility is defined by U = I ? e2 and his reservation wage is $2,000 per week. FancyFoods costs = Malone's wages = $2,000 + e2 FancyFoods benefits = revenue = 300e Profits = Revenues ? Costs Compute the optimal wage bill for Chef Malone, the revenues for FancyFoods, and the profits earned by FancyFoods.
What will be an ideal response?
The firm will offer the chef a compensation contract that would pay him a sum of money if and only if he provides a specified level of effort. With this type of contract the firm's decision problem is to decide which level of the chef's effort maximizes profit while meeting or exceeding the chef's reservation wage. We set marginal revenue equal to marginal cost and solve for effort. Marginal revenue is 300 for every additional hour of effort. Marginal cost is 2e, the first derivative of total costs. Solving for effort, e = 150 per week. Therefore the optimal wage bill is 2000 + (150)2 = 24,500. FancyFood's revenue is 300(150) = $45,000 and profits are $20,500.
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