Personnel Economics (BU3101)
Problem Set 2 (50 points)
Due Date – 22nd November 2024
Name: ____________________________ Roll Number _______________
Sem: ____________________ Major ______________________
Question 1: (15 Marks)
Maya is a project manager in a tech start-up. Her utility function is U(W)=W ½. Maya’s employer offers
her a choice between two compensation structures: (i) a Performance-Linked Bonus (PLB) scheme, and
(ii) a fixed salary structure. The PLB scheme links a portion of her income to project outcomes, which
Maya expects will either yield $64 (with ½ probability) or $196 (with ½ probability).
A. What is the expected income and utility Maya would expect to earn from the PLB scheme? (2 marks)
EV = 0.5* 64 + 0.5 * 196 = $130
EU = 0.5 (64)1/2 + 0.5 (196) ½ = 11
B. What is the minimum fixed wage Maya would be willing to accept to avoid the risk associated with the
stock options scheme (certainty equivalent) and how much income would she be willing to give up
eliminating the uncertainty of the stock options (risk premium)? (2 marks)
EU = W1/2
W = (11)2
W = CE = 121
RP = 130 – 121 = 9
C. If Maya’s income(W) = 0.5, Measurement Error (𝜎2ε) = 0.5 and her cost of effort C(e)= 0.2e2.
If her employers were considering a third compensation structure where a part of her income was
performance based, her Compensation function would be:
Pay = a + b (Performance Measure)
What should the optimal incentive intensity (b*) in her compensation structure be? (3 marks)
b* = 1/ 1+ (R* 𝜎2ε *C’’(e), where R is Arrow Pratt measure of risk aversion
R = = -0.25 W-1.5 /0.5 W -0.5 = 1/2W = 1/1= 1
b = 1/ 1+ (1*0.5*0.4) = 1/ 1+0.2 = 1/1.2 = 0.8333
D. Given the incentive intensity b and the marginal cost of effort C’(e), determine the following: (5
marks)
a) The optimal effort level e that the Maya should exert.
b) The corresponding cost of effort C(e) at this optimal effort level.
c) The optimal base salary a such that the firm should set so that the employee’s compensation
satisfies the participation constraint a+b⋅e = C(e)
Optimal effort level e that the Maya should exert, where b = C’(e)
0.833 = 0.4e
e* = 2.0825
C(e) = 0.2 e 2 = 0.2 (2.0825)2 = 0.867
a+b ⋅e = C (e)
a + 0.833*2.0825= 0.867
a + 1.735 = 0.867
a = -0.868
E. Maya's colleague Jaya has the same utility function, income and expectations as Maya. Jaya’s cost
function is C(e) = 0.8e2. What will be Jaya’s optimal incentive intensity? Will Jaya’s optimal incentive
intensity be lower or higher than Maya’s optimal incentive intensity? Explain why. (3 marks)
C’’(e) = 1.6
b* = 1/ 1+ (R* 𝜎2ε *C’’(e) = 1/ 1+ (1*0.5*1.6) = 1/1+(0.8) = 0.556
The reason is that the more rapidly that extra effort becomes more onerous (the larger is C′′), the lower
the commission rate. This is because additional effort becomes increasingly costly to motivate.
Q2. (10 marks)
Suppose we have a risk-neutral landlord and a risk-neutral farmer who have to decide on a contract that
will determine how the farmer is paid. The output on the land depends on how much effort the farmer
puts in. Output on the farm is ln(e), where e is the amount of effort that the farmer puts in. The farmer
has a constant marginal cost 0.25 of providing a unit of effort, so the cost of providing effort e is 0.25e.
Now, suppose there are two contracts that the landlord can choose from. They are:
1. Fixed rent with rent of 0.5 and farmer will get all the output produced.
2. Sharecropping with the landlord getting ½ of the output.
a) What will be the farmer’s effort level and total output in either case. (5 marks)
Farmer will choose effort level to optimize his pay
In Fixed rent
By FOC
1/e – 0.25 = 0
e=4
output = ln(4) = 1.38
In sharecropping
½*1/e – 0.25 = 0
1/2e = 0.25
e=2
Total Output = ln(2) = 0.69
b) What contract shall the landlord choose? (3 marks)
Under the fixed rent contract, the landlord gets income of 0.5
Under the sharecropping contract
The landlord gets half of the output, so the landlord gets ½ ln(2) = 0.35
The landlord makes more under the fixed rent contract and chooses the fixed rent contract.
c) Based on the landlord’s chosen contract, will the farmer’s net financial pay? (exclude the cost of
effort) (2 marks)
Under fixed rent contract,
The farmer’s pay = 1.38 – 0.5 = 0.88
Question 2: THE FLATTENING FIRM: EVIDENCE FROM PANEL DATA ON THE CHANGING
NATURE OF CORPORATE HIERARCHIES
Raghuram Rajan Julie Wulf (10 marks)
The paper finds that CEO span of control (the number of direct reports) has increased significantly over
time, while the number of layers between the CEO and operational managers has decreased. The authors
suggest that this may represent both centralization (more direct oversight by the CEO) and
decentralization (increased decision-making authority at lower levels).
A) Refer to Table 2 & 4 to analyze how the increase in CEO span of control might affect the speed and
quality of decision-making within the firm. Use data from the table to support your
answer. (5 Marks)
Solution - An increase in CEO span of control (i.e., the number of direct reports) affects decision-making
in following ways:
Speed: With more managers directly reporting to the CEO, decisions might be made faster
because fewer layers of communication are involved. Table 2 shows that the average number of
positions reporting directly to the CEO increased from 4.46 (mean) in 1986 to 6.79 (mean) in
1998 for the whole sample, and from 4.39 to 8.16 for the balanced sample over the same period.
This significant increase in span of control suggests that CEOs are interacting directly with more
managers, which can enable faster decision-making by reducing the layers through which
information must travel.
Quality: However, as the number of direct reports increases, the CEO’s ability to provide detailed
oversight decreases. With CEO span increasing by 86% in the balanced sample, the CEO may
find it difficult to monitor all direct reports closely, which can compromise decision quality. This
creates a trade-off between faster decision-making (due to fewer layers) and the potential for less
detailed oversight.
B) Use the data from Table 7 to explain how long-term incentive pay is used to align the interests of
divisional managers with the firm’s overall performance as the CEO’s span of control increases. Refer to
the specific coefficients and results in Table 7 to support your
explanation. (5
Marks)
Solution: In Table 7, column (iii), the OLS coefficient for DDEPTH is -0.063, indicating that for each
additional layer between the CEO and the divisional manager, the ratio of long-term incentive pay to
salary plus bonus decreases by 6.3%. Similarly, in column (iv) (Division Fixed Effects), the coefficient
remains significant at -0.058, meaning that even after accounting for division-specific factors, an
additional layer between the CEO and divisional managers leads to a 5.8% reduction in long-term
incentives. This means that as divisional managers move closer to the CEO, their compensation is
increasingly tied to the firm's performance through stock options and long-term incentives, which help
align their objectives with those of the firm. So, long-term incentives are crucial for compensating for the
lack of direct oversight from the CEO.
Q4. Research Project Results (15 marks)
Show the items below to your mentor by 22nd November 2024 (Friday). Prepare a 2-page report and share
with your mentor. This should include a preliminary analysis of the group project your team proposed
during the Mid-Sem presentation. This will let you receive feedback before the final presentation.
Depending upon the project, this will include:
A) The summary statistics on the dataset you are using for your project or have created from
scratch, including definitions of key features and the methodology of collecting data.
Visualizations may be helpful here as well.
B) Show the identification strategy you are using for your project along with preliminary
results thus far.
C) Do the results support or contradict your initial hypothesis? How are you planning to
extend the existing results? Will you be running any robustness checks? Mechanism
checks?
D) Are your results consistent or in contradiction with the economic theory? What literature
does this paper add to?
Note that for Final Semester Presentation, expectations include -
Literature review and Background of the problem
Dataset explanation (e.g., which variables you are using) and/or how you collected the data
Hypothesis
Main regression equation (especially if using Path 2)
A note on the Empirical Methodology
Summary Statistics
Empirical analysis
Secondary Results and Robustness Checks
Policy Implication
Conclusion
A summary report of the project with data and code files and individual contributions
accompanying the presentation. The above question will help in creating a preliminary
version of this report.