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Solutions To Session 6 Practice Problems

This document provides solutions to practice problems from a Managerial Economics course. It summarizes the solutions to 5 problems: [1] Calculating utility values for different payoffs given risk neutrality; [2] Explaining moral hazard in the context of product warranties; [3] Comparing insurance policies and moral hazard for property insurance; [4] Determining optimal effort levels for managers under different compensation packages; [5] Structuring optimal compensation for a worker given different wage formulas. The solutions are intended to help students understand economic concepts, not just memorize answers.

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Keshav sood
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69 views3 pages

Solutions To Session 6 Practice Problems

This document provides solutions to practice problems from a Managerial Economics course. It summarizes the solutions to 5 problems: [1] Calculating utility values for different payoffs given risk neutrality; [2] Explaining moral hazard in the context of product warranties; [3] Comparing insurance policies and moral hazard for property insurance; [4] Determining optimal effort levels for managers under different compensation packages; [5] Structuring optimal compensation for a worker given different wage formulas. The solutions are intended to help students understand economic concepts, not just memorize answers.

Uploaded by

Keshav sood
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Managerial Economics

Indian School of Business


Term 1, 2019-20

SOLUTIONS TO PRACTICE PROBLEMS FROM SESSION 6

The solutions presented here are to assist you to understand the concepts presented in the lectures.
Memorizing the solutions is not a substitute for thinking hard about the principles of microeconomics
and the problems assigned to you for practice, as homework or on exams. In writing up these answers,
I have relied on my own solution as well as solutions worked out by past students, Academic Associates
and the solutions manual accompanying the Allen text. Even if you feel confident about your solution,
consult other students to see their approach to problem solving. Also feel free to consult the Academic
Associates or me at any time.

Problem 1
Because Xander Kreck is risk neutral, the relationship between his payoffs and the utility
derived from them is linear.

U (M $100, 000) = 0; U (M $200, 000) = 1


1
Calculate slope = 100,000

Solve using equation of a line to get U (M $400, 000) = 3 and U (−M $20, 000) = −1.2

Problem 2

a. In the past, customers perceived American automobiles to be of low quality. To


reverse this trend, American companies invested in quality control, improving the
reliability and decreasing the repair and maintenance needs of the cars they pro-
duced. In order to signal the quality improvement in their products, they offered
longer warranties.

b. Moral hazard occurs when the party to be insured (in this case, the owner of an
American car with a seven year warranty) can influence the probability or the
magnitude of the event that triggers payment (the repair of the automobile). If the
manufacturer covers all parts and labor associated with mechanical problems, the
owner has lower incentive to drive carefully or maintain the automobile. Hence, a
moral hazard problem is created with extensive warranties.

Problem 3
Moral hazard problems arise with fire insurance when the insured party can influence
the probability of a fire. The property owner can reduce the probability of a fire or
its impact by inspecting and replacing faulty wiring, installing warning systems, etc.
After purchasing complete insurance, the insured has little incentive to reduce either the

1
probability or the magnitude of the loss, so the moral hazard problem can be severe. In
order to compare a Rs. 10,000 deductible and 90 percent coverage, we need information
on the value of the potential loss. Both policies reduce the moral hazard problem of
complete coverage. However, if the property is worth less (more) than Rs. 100,000, the
total loss will be less (more) with 90 present coverage than with the Rs. 10,000 deductible.
As the value of the property increases above Rs. 100,000, the owner is more likely to
engage in fire prevention efforts under the policy that offers 90 percent coverage than
under the one that offers the Rs. 10,000 deductible.

Problem 4
√
Case 1. Utility from low effort is 5750000 = 2397.9158
√
Utility from high effort is 575000 − 100 = 2297.9158
⇒ Hence, the manager will put in low effort.

Case 2. Utility from low effort is


√ √ √
(0.3 ∗ 5cr ∗ 0.06 + 0.4 ∗ 10cr ∗ 0.06 + 0.3 ∗ 15cr ∗ 0.06) = 2399.4111
Utility from high effort is
√ √ √
(0.3 ∗ 10cr ∗ 0.06 + 0.4 15cr ∗ 0.06 + 0.3 ∗ 17cr ∗ 0.06) − 100 = 2792.97
⇒ Hence, the manager will put in high effort.
√
Case 3. Utility from low effort is 5000000 = 2236.068
Utility from high effort is

√ √ p
0.3∗ 5000000+0.4∗ 5000000+0.3 (5000000 + 0.5 ∗ (17cr − 15cr))−100 = 2627.1426
(1)
⇒ Hence, the manager will put in high effort.

Expected profit from choosing the first package when managers put in low effort =
94250000

Expected profit from choosing the second package when managers put in high effort
= 132540000

Expected profit from choosing the third package when managers put in high effort
= 133000000

Hence, the firm would offer compensation package 3 to the manager, as the expected
profits (net of manager salary) is the highest.

Problem 5

2
a. w = 2 for e ≥ 1, otherwise w = 0
Since the worker’s wage is independent of revenue and fixed at 2 for effort levels
greater than equal to one and zero otherwise, she will exert either exactly one unit
of effort or none at all. If she exerts one unit of effort her net benefit (w − e) is
1, otherwise she receives a payoff of zero. Therefore, her optimal choice would be
to exert one unit of effort and the firm will realize a profit of 7. Note that this
compensation structure cannot be used unless the worker’s effort is observable; this
is often not the case, as we saw in the previous question.
R
b. w = 2

Since the worker chooses to maximize wage less effort i.e. w − e


2 2
max w − e ⇒ max R2 − e = max 10e−e
2
− e ⇒ max 8e−e
2

Solve to get e = 4 and w = 12


Profit is revenue minus costs which works out to be 12

c. w = R − 12.5

Since the worker chooses to maximize wage less effort i.e. w − e


max w − e ⇒ max R − 12.5 − e = max 10e − e2 − 12.5 − e
Solve to get e = 4.5 and w = 12.25
Profit is revenue minus costs which works out to be 12.5

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