Chapter 14 Principal–Agent Issues and Managerial Compensation
MULTIPLE CHOICE
1. The principal–agent problem occurs as a result of:
a.
the absence of a contract between managers and owners
b.
the separation of ownership from management
c.
the difficulty of identifying the principal agent with whom to negotiate
d.
competition between managers at various levels
e.
none of the above
2. Principal–agent problems can exist between:
a.
workers and managers
b.
workers and owners
c.
workers and customers
d.
owners and customers
e.
all the above
3. A technique for dealing with the principal–agent problem is to:
a.
require managers to purchase shares of stock in the firm
b.
establish a profit-sharing plan for managers
c.
establish year-end bonuses based on the profits of the firm
d.
all the above
e.
none of the above
4. The moral-hazard problem occurs when:
a.
a consumer of insurance changes his or her behavior in such a way as to decrease
the probability of a payoff
b.
a consumer of insurance changes his or her behavior in such a way as to increase
the probability of a payoff
c.
insurance companies change their behaviors in such a way as to increase the
probabilities of a payoff
d.
insurance companies change their behaviors in such a way as to decrease the
probabilities of a payoff
e.
none of the above
5. Consider Mr. Ed, who purchases an insurance policy on a thoroughbred that he has
acquired. He then proceeds to run the horse even though the horse has tendinitis. This is an
example of:
a.
an adverse-selection problem
b.
a moral-hazard problem
c.
coinsurance
d.
signaling
e.
all the above
6. The savings and loan crisis of the early 1990s was caused by a moral-hazard problem
because:
a.
government insurance encouraged bank managers to take on more risk than they
would have without such insurance
b.
bank managers no longer attempted to maximize the profits of the firm
c.
insurance attracted depositors who would not have used banks otherwise
d.
depositors had more information about the banks than shareholders had
e.
government insurance encouraged bank managers to take on less risk than they
would have without such insurance
Suppose that Wilma’s utility function is given by
U(E) = 100 − 2E 2,
where E = Wilma’s work effort in producing homemade dinners, measured in hours per day.
Please use this utility function to answer the following questions.
7. The marginal utility of effort for Wilma is:
a.
2E 2
b.
−2E
c.
100
d.
−4E
e.
none of the above
8. If Wilma is forced to work an 8-hour day producing homemade dinners, her total utility will
be:
a.
100
b.
−28
c.
−128
d.
228
e.
none of the above
9. Given her utility function, Wilma has an incentive to supply:
a.
maximum effort, since working hard is important to her
b.
maximum effort, since she is afraid of getting fired
c.
minimum effort, since she knows she will get fired under any circumstances
d.
minimum effort, since her utility decreases as effort increases
e.
maximum effort, since she can increase her salary by working harder
Please use the following profit function (per worker) for the Blue Delta Faucet Company to
answer the following questions:
P(e) = 40e − (2e2 + 100)
Note that P = firm profits and e = worker-hours per day. Assume that effort is observed
perfectly.
10. What is the profit-maximizing level of effort for the firm to set for workers?
a.
There is no effort level that maximizes profits in this case.
b.
3.16 hours per day
c.
8 hours per day
d.
10 hours per day
e.
12 hours per day
11. At this profit-maximizing level of effort for the firm, profits per worker will be:
a.
$40
b.
$100
c.
$300
d.
$400
e.
none of the above
12. At the profit-maximizing level of effort for the firm, daily per-worker compensation will be:
a.
$100
b.
$200
c.
$300
d.
$340
e.
none of the above
13. If effort is unobservable and revenues are riskless, firms can design incentive-compatible
compensation schemes by offering workers:
a.
profit shares
b.
increased nonmonetary benefits
c.
increased fixed salary
d.
decreased effort requirements
e.
increased future compensation in the form of retirement pay
14. Incentive-compatible employment contracts exist when:
a.
the firm and workers have the same objective
b.
owners and managers have the same level of income
c.
incentives of owners and managers are compatible with, though not necessarily the
same as, one another
d.
owners and managers have the same objectives as consumers of the products they
produce
e.
base pay for managers is equal to the profit share they realize
15. Optimal employment contracts for managers, given revenue risk and unobservable output,
consist of:
a.
a flat salary alone
b.
a flat salary plus some return to estimates of effort
c.
only a profit share
d.
a flat salary plus a profit share related only indirectly to individual effort
e.
a flat salary plus a profit share that is equal to the share accruing to owners
16. Donald has a beach house on the Outer Banks of North Carolina that was severely damaged
in the most recent hurricane to strike the coast. Due to beach erosion he has rebuilt twice in
the past 20 years. He is intent on rebuilding, confident that government-provided flood
insurance will cover his expenses. This is an example of:
a.
how market-based solutions to problems are superior to government solutions
b.
moral hazard
c.
adverse selection
d.
asset substitution
e.
none of the above
17. Creditors and shareholders may have an incentive incompatibility because:
a.
shareholders can declare bankruptcy and hence have limited liability
b.
creditors must bear less risk than shareholders
c.
creditors can call debt if better opportunities arise
d.
shareholders choose projects with less risk than creditors would like
e.
none of the above; creditors and shareholders are both interested in maximizing the
profits of the enterprise
Please use the diagram below to answer the following questions. Consider this decision tree,
which represents the outcomes of two alternative projects that the Ink, Inc., a producer of
printers, might pursue. Ink, Inc., needs to borrow $1,000 to pursue either project and is
going to sell bonds to finance the venture.
18. According to the expected value criteria, which project should be chosen?
a.
project A
b.
project B
c.
neither project A nor B; both have a negative expected value
d.
either project A or B; both have the same expected value
19. Ink, Inc., is carrying a large amount of debt because of overexpansion during the dot-com
explosion. Under these circumstances, the shareholders would tend to choose:
a.
project A, since it has the highest expected value
b.
project B, since it has the greatest degree of risk
c.
project A, since it has the lowest degree of risk
d.
neither project A nor B, since both are risky
e.
either project A or B; both have the same degree of risk
20. Under these circumstances, bondholders and shareholders may have incompatible incentives
since:
a.
shareholders know that they have limited liability because of their ability to
declare bankruptcy
b.
bondholders are not profit maximizers
c.
shareholders are not profit maximizers
d.
bondholders have limited liability because insurance against risk is provided by the
federal government
e.
shareholders insure bondholders against risk
21. Firms can avoid or limit the asset substitution problem by:
a.
funding with equity
b.
establishing a reputation for protecting creditors
c.
insuring bondholders against risk
d.
applying to the government for insurance for bondholders
e.
a, b, or c
22. In recent years, individuals and state governments have sued various tobacco companies to
compensate for illness and injury allegedly caused by cigarette smoking. Courts have
awarded millions of dollars to victims in these cases. This product liability law:
a.
encourages firms to ignore safety issues when developing products
b.
creates an incentive incompatibility between producers and consumers
c.
encourages incentive compatibility between producers and consumers
d.
is the only way to achieve compatible incentives when consumer safety is at issue
e.
forces firms to declare bankruptcy and to default on bondholders
23. A manager has a utility function U = C 0.5 if she doesn’t work hard and U = C 0.5 − 1 if she
does. Expected profit will increase from 1,500 to 1,600 if she works hard. The manager
receives compensation C equal to 81 plus a portion x of any profit in excess of 1,500. What
is the value of x that will make the manager indifferent between shirking and working hard?
a.
0.09
b.
0.105
c.
0.19
d.
0.242
e.
none of the above
24. A manager has a utility function U = C 0.5 if she doesn’t work hard and U = C 0.5 − 1 if she
does. Expected profit will increase from 1,400 to 1,600 if she works hard. The manager
receives compensation C equal to 82 plus a portion x of any profit in excess of 1,400. What
is the value of x that will make the manager indifferent between shirking and working hard?
a.
0.09
b.
0.105
c.
0.19
d.
0.242
e.
none of the above
25. A manager has a utility function U = C 0.5 if she doesn’t work hard and U = C 0.5 − 3 if she
does. Expected profit will increase from 1,000 to 1,500 if she works hard. The manager
receives compensation C equal to 144 plus a portion x of any profit in excess of 1,000. What
is the value of x that will make the manager indifferent between shirking and working hard?
a.
0.09
b.
0.105
c.
0.19
d.
0.242
e.
none of the above