Homework Problem Set 3

1. For each of the following statements, state whether you agree or disagree and give
explanations for your answer.
a) If executive pay scales are related to long-term performance, they are more likely to
work in accordance with the wishes of the stakeholders of the company.
b) If banks charge high interest rates on credit cards, they are likely to attract more
defaulters.
c) A washing machine should be sold with a two-year warranty and not a life-time
warranty.
2. A risk-averse manager at Anokhi is thinking of expanding investments in its two lines of
business, ready-made garments and continental food. He can either spend the money on
one line of business alone or jointly expand investment in both the businesses. There is a
90 per cent chance of a boom and a 10 per cent chance of a recession. In case of a boom,
the ready-made garments will rake in a profit of Rs 20 crores while the continental food
business will suffer a loss of Rs 10 crores. In contrast, in case of a recession, the food
business will do well by earning Rs 12 crores but the ready-made garments business will
see losses worth Rs 8 crores. What should the manager do? Why?
3. Suppose you want to do outsource some your operations to Afghanistan to exploit the
low wages prevailing there. But the law is lax there and it is difficult to enforce contracts.
You employ an agent and pay him a wage w, while the going wage is 1. Outsourcing
requires an investment in machinery of 1 that needs to be sent to the agent. If the project
succeeds, the revenue earned is 4. But the agent can just take the money sent to him and
go away. If the agent decides to cheat, he gets 2 (investment money of 1 and the going
wage 1 from his normal job) and you will lose 1 (investment money of 1). If the agent is
honest, you will get 3 (revenue of 4 less 1 of investment) less the wage w and the agent
earns the wage w that you set. Assume that this is a two-stage game where you have to
decide whether to invest or not in the first stage and in the second stage, the agent has to
decide whether to be honest or cheat. What is the equilibrium wage w if
a) it is a one-shot game with no future.
b) probability of the game continuing in the future is 1.
c) there is a half-half chance of the game continuing in the future.