John’s daily productivity depends upon his skill, his time on the job, and the effort he makes. Suppose that in a given day of work, he has a choice of how much effort (E) to expend. The following table shows the cost to John of expending each added unit of effort and the corresponding benefit to the firm of the added unit of his effort:

a. What is John’s best effort level?

b. If the firm pays John by the hour (and there is no way they can monitor his effort level), how much effort will he put forth?

c. Suppose the firm can observe John’s effort, what price should they be willing to pay (assuming they pay the same price for each unit)? How might the firm increase its profits by paying a different price for each unit of effort?

d. Suppose that the firm cannot observe John’s effort but offers him 50 percent of its profits (the increase in profits from more E is assumed to equal the marginal benefit to the firm of more E).
How much E will John put forth?

e. Suppose the firm has five workers and it splits all its profits among all five workers such that each gets a fifth of its profits.
How much effort will each worker put forth? Suppose instead that workers are in a team and the team gets the full profits? How many units of effort will the team, as a group, be willing to supply?

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1 2 3 4 5 E John's Effort Marginal Benefit to Firm of Added Unit Effort $50 $40 $30 $20 $10 Marginal Cost to John of Added Unit of Effort $5 $10 $15 $20 $25