# Which of the two contracts in parts a. and b. would Anika prefer?

Instructions I – A Managerial problem I Curtis manages an electronics store in Wichita, Kansas. He considers carrying either cameras from Nikon Americas that come with a U.S. warranty or gray market Nikon cameras from a European supplier, which are the same cameras but their warranties are only good in Europe. The gray market cameras have a lower wholesale price. Curtis earns 10% of the store’s profit (and no wage). If the store loses money, he leaves with nothing. He believes that if he sells the Nikon Americas cameras, the store’s profit will be \$400,000. The profit on the gray market cameras is more uncertain—will locals be willing to buy a less expensive camera without a warranty? If he sells the gray market cameras, he believes that he has a 50% chance that the store’s profit will be \$1,000,000 and a 50% probability that the store will lose \$300,000. Curtis and the store’s owner are both risk-neutral. Which camera does Curtis choose to sell? What choice would the owner prefer (if she were fully informed)? Construct an alternative compensation plan involving a salary such that Curtis will earn as much from selling Nikon Americas cameras as from selling gray market cameras, and that will dissuade him from selling gray market cameras if doing so lowers the owner’s expected earnings. II – A Managerial problem II Anika is hired by the owner of a kitchen supply store to manage the store. Anika and the owner are both risk-neutral. The probability of weak demand is 0.2, and the probability of strong demand is 0.8. Each cell in the following table shows the store’s profit from a specific combination of demand and Anika’s managerial effort. Anika’s cost of effort is not subtracted from these profits. This effort cost is 2 for low effort, 10 for medium, and 32 for high. Weak Demand Strong Demand Low Effort 40 60 Medium Effort 60 100 High Effort 100 140 Create a spreadsheet containing this information. Add a column showing Anika’s cost of effort and also add columns for the expected payoff to Anika and the owner. Fill in the expected payoffs to both parties if Anika is compensated with a profit-sharing contract providing her with 50% of the profits (and the owner gets the other 50%). Which effort level does Anika choose? Now suppose that Anika’s contract provides her with a base salary of 30 and 100% of any profits exceeding 100. Which effort level does she choose? Which of the two contracts in parts a. and b. would Anika prefer? Which would the owner prefer?

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