This question works off the set up in the example on page 522 of the text. Two workers, Conrad and Dina produce 5*E units of output each working individually where E is the amount of effort that they provide. Dina's output working individually is 5*EDI and Conrad's output working individually is 5*ECI. The subscript "I" denotes effort working individually and the subscript "T" denotes effort working on a team. If they work as a team and coordinate their effort, their joint output as a team is Team Output = 2*(EDT + ECT)2. Don't let the math of the team output equation freak you out. It is just a function that captures the salient aspect of a synergistic team: the impact on team output of Conrad putting forth additional effort depends on how much effort Dina provides which is not the case when they work individually. The team output is greater than the sum of the individual outputs so long as EDT + ECT > 10. The amount of effort Dina and Conrad provide depends on their incentives. With a bonus contract that is percentage of output (x%), the marginal return to output from a unit of additional effort working individually is 5 for all levels of EDI and ECI and the marginal bonus to the individuals from an additional unit of effort is x%*5. With team production, the two workers split the credit for the output, so the marginal return to an additional unit of effort is 2*(EDT + ECT) and the marginal bonus for an additional unit of effort is Y%*2*(EDT + ECT).1 Marginal Out Per Unit of Effort Marginal Bonus Per Unit of Effort As Individuals 5 5*X% As a Team 2*(EDT + ECT) 2*(EDT + ECT)*Y% 1 The team output is 2*(EDT + ECT)2. The individual's share for performance purposes is half of the total: (EDT + ECT)2. The marginal return to a unit of effort is the derivative of individual's share with respect to effort.

3 The two workers have weaker incentives when placed on a team unless Conrad is confident that Dina will put forth a certain level of effort and vice versa. How would you modify the objective bonus contract to make Conrad is confident that Dina will put forth a certain level of effort and vice versa? Notes: There are somethings that you are not allowed to do. You cannot play Santa Claus with the shareholder's money and make Y% larger. You cannot switch to a subjective bonus program because it is prohibitively costly to measure Dina and Conrad's effort in team setting.