Kelsey, the owner of Kelsey's Business is interviewing Kristen for the position of manager while she pursues
Question:
Kelsey, the owner of Kelsey's Business is interviewing Kristen for the position of manager while she pursues other interests. Kelsey Knows from her experience that if the manager works hard, the company will earn cash flows of $1,000 with a probability of 0.8, and earn cash flows of $700 with a probability of 0.2. If the manager shirks, the cash flows are $1,000 with a probability of 0.2 and $700 with a probability of 0.8.
However, cash flows will not be known until the end of two years, and Kelsey decides to base managerial compensation on net income will be on net income according to GAAP. She knows that when cash flows are $1,000, then net income will be $1,200 with a probability of 0.7 and $450 with a probability of 0.3. However, when cash flows are $700, net income will be $1,200 with a probability of 0.3 and $450 with a probability of 0.7.
Net income is before the manager's compensation. Kristen has a square root utility for money received and her reservation utility is 2.6. If Kristen works hard, her disutility of effort is 8 and if she shirks, her disutility of effort is 7. Kelsey offers Kristen 16% of net income as compensation.
Determine whether Kristen will accept the contact. Show calculations of her utility to two decimal places. Also, indicate whether Kristen will work hard or shirk.
