This homework is on the simplest possible version of the principal-agent model. It is this model that produces pay for performance as a feature. It is important to understand this base model before we delve into various realistic ways of complicating the model. (Mostly we will talk about that but I might do some additional modeling in class after going over the basic model.) There is a video I'd like you to watch first. I should give you the background you need to do the homework.

Video

The actual homework.

In the section for the first graph, I'm having trouble solving for the WL intercept. I successfully solved for the WH intercept, but after using this number to computer the WL intercept, I keep getting WL equal to zero. Is there some way to fix this?

ReplyDeleteAre you talking about the questions on lines 59 and 60? The equation of the iso-expenditure line is:

Deletep*wL + (1-p)*wH = Expected Expenditure.

The right hand side of that equation is given in cell G58, while the value of p is given in cell D58. The last bit that you need to know is to get the wH intercept set wL = 0 in the above equation and to get the wL intercept set wH = 0 in the above equation.

This makes much more sense. Thanks!

DeleteHigh Professor Arvan, I have a question for the cell G94. I typed in "=((C86-C82*G58^C85)/(1-C82))^(1/C85)", which is according to the equation given above in line 79. But it turned out wrong and I don't know what's the problem. Can you help me with that? Thx!

ReplyDeleteYou don't seem to be understanding what the question is asking for. So I won't critique your algebra, but instead ask what are you trying compute? Note, that unlike in the question posed by Armen Alchian above, now we are on an indifference curve, not an iso-expenditure line. In cell G94, you are supposed to give the certainty point on that indifference curve. We solved for that in an earlier homework? What did we call it there? If you know how to do the earlier homework, you should be able to solve for what is in cell G94 as well.

DeleteI read through the question and now understand what it actually is asking for. Sorry about that. Thx!

DeleteHi Professor Arvan,

ReplyDeleteI have two quick questions regarding the high effort IR and IC curves. First, why aren't the certainty equivalent points the same for both the high and low effort curves? And second, how does "e" factor into computing the Wh for the high effort curve? Thanks!

The high effort indifference curve includes compensation both for the outside option and for effort. The low effort curve only includes compensation for the outside option. In other words, the high effort curve compensates the agent to ubar + e. The low effort curve compensates the agent only to ubar.

ReplyDeleteI have a question concerning the cell B96. Im using the formula given to solve WH with respect to a given WL but I keep on getting an extremely large number that is not the answer. Could I get a clue or an explanation on how to tackle this problem? Thank you.

ReplyDeleteHow large is large? I'm not sure what to tell you other than to try do the formula in pieces in different cells and then build it up from the primitives. Perhaps you've made a simple error that you are not seeing by trying the entire formula in one fell swoop.

Delete