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Chapter 16: Problem 16

After years of training, Sara has landed a contract playing professional lacrosse. Eager to leverage her pro status by bringing in endorsements, she asks Jenny MacGuire to be her personal manager. Jenny has offered Sara a choice of two payment plans. Sara can engage Jenny's services for a flat fee of \(\$ 100,000\). Alternatively, Sara can pay Jenny \(15 \%\) of all endorsement revenue. Sara estimates that if Jenny expends modest effort ( \(\$ 20,000\) worth) in her job, she will generate \(\$ 600,000\) in endorsement revenue for Sara. But if Jenny expends high effort ( \(\$ 50,000\) worth), she will bring in \(\$ 1\) million in endorsements. a. Suppose Sara agrees to the flat-rate plan. What can Sara expect to receive if Jenny expends modest effort? If Jenny expends high effort? What can Jenny expect to receive in either case? Explain the associated principal-agent problem. Who is the principal? Who is the agent? b. For both possible effort levels, determine the rewards to Jenny and Sara if Sara chooses the \(15 \%\) plan. What happens to the principal-agent problem if Sara chooses this plan?

Short Answer

Expert verified
Flat plan: Jenny earns $100,000 regardless of effort; principal-agent problem exists. Percentage plan motivates Jenny to exert high effort, reducing the problem.

Step by step solution

01

Understand Payment Plans

Sara has two payment options for her manager Jenny. The first option is a flat fee of \( \$100,000 \), and the second option is to pay Jenny \( 15\% \) of all endorsement revenue Jenny helps to generate.
02

Calculate Expected Income and Costs with Flat Plan

If Jenny uses modest effort generating \( \\(600,000 \) in revenue, Sara's expected income after paying the flat fee is \( \\)600,000 - \\(100,000 = \\)500,000 \). Jenny's income is \( \\(100,000 \).If Jenny uses high effort generating \( \\)1,000,000 \) in revenue, Sara's income is \( \\(1,000,000 - \\)100,000 = \\(900,000 \). Jenny's income remains \( \\)100,000 \).
03

Identify Principal-Agent Problem with Flat Plan

The principal-agent problem arises because Jenny, as the agent, might not be motivated to exert high effort if her income doesn't change. Sara is the principal, and Jenny is the agent. This payment structure may lead to inefficiency due to effort mismatch.
04

Calculate Rewards with Percentage Plan (Modest Effort)

For modest effort with \( \\(600,000 \) in revenue, Jenny earns \( 0.15 \times \\)600,000 = \\(90,000 \). Sara receives \( \\)600,000 - \\(90,000 = \\)510,000 \).
05

Calculate Rewards with Percentage Plan (High Effort)

For high effort with \( \\(1,000,000 \) in revenue, Jenny earns \( 0.15 \times \\)1,000,000 = \\(150,000 \). Sara receives \( \\)1,000,000 - \\(150,000 = \\)850,000 \).
06

Principal-Agent Problem with Percentage Plan

With the percentage plan, Jenny is incentivized to exert high effort because her income increases with higher revenues. This reduces the principal-agent problem, aligning Jenny's interests with Sara's aim for higher revenues.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Flat Fee Contract
In a flat fee contract, a manager like Jenny receives a predetermined payment, irrespective of the effort exerted or revenue generated. Sara's flat fee offer to Jenny is set at \( \$100,000 \). This type of contract is straightforward and provides certainty for both parties involved. However, it doesn't always motivate the manager to increase their level of effort beyond what is necessary.

With such contracts, whether Jenny puts in modest or high effort, her earnings stay the same. This might lead to a situation where Jenny prefers to exert a minimum amount of effort since her compensation won't increase with more work. Flat fee contracts provide predictability, but they might not always align the objectives of the manager (agent) with the goals of the athlete (principal).

In this scenario, Sara stands as the principal because she delegates a task, and Jenny becomes the agent who carries out the task. The challenge here is that Jenny may not have enough financial incentive to maximize potential revenue, which becomes a notable aspect of the principal-agent problem.
Percentage-Based Incentive
Unlike a flat fee contract, a percentage-based incentive ties the manager鈥檚 earnings directly to the revenue they generate. In Sara's case, Jenny would earn \( 15\% \) of endorsements she helps secure. This model encourages Jenny to work harder since her income grows with the increase in the total endorsement revenue.

For example, with a revenue of \( \\(600,000 \) from modest effort, Jenny earns \( \\)90,000 \), while a high effort resulting in \( \\(1,000,000 \) raises her earnings to \( \\)150,000 \). Clearly, this compensation structure directly aligns Jenny's financial interests with Sara鈥檚 revenue goals.

Therefore, the percentage-based incentive aligns their objectives more closely and reduces the principal-agent problem by motivating Jenny to exert higher effort for greater income. This structure offers a dynamic approach, allowing both the principal and the agent to benefit proportionally from increased revenues.
Effort Level
Effort level is a crucial factor impacting the total outcomes in any contract situation. In this scenario, Jenny's work effort directly influences Sara's endorsement revenues. With a modest effort investment, Sara estimates generated endorsements of \( \\(600,000 \), but with high effort, this could increase to \( \\)1,000,000 \).

The principal-agent problem highlights the potential misalignment when the agent does not have enough motivation to exert high effort under a flat fee model. Here, Jenny's lack of higher compensation with increased effort can lead to exerting only the minimal required effort. Therefore, it is essential to select a contract that effectively motivates Jenny to consistently choose higher effort levels.

Integrating the right incentive structure can significantly raise the agent's effort level, eliminating inefficiencies and aligning interests. By incentivizing increased effort through better-aligned compensation models, both parties reap greater benefits.
Endorsement Revenue Management
Effective endorsement revenue management is key to maximizing the gains from professional sports contracts. Sara's revenue depends on endorsements managed effectively by Jenny. The right balance between fixed fees and incentives can enhance the management of these endorsements.

Flat fee contracts offer certainty and manageability. Still, they may not entirely incentivize high revenue generation unless paired with a performance metric. On the other hand, percentage-based incentives can dynamically enhance revenue outcomes, encouraging rigorous management of endorsements.

In this scenario, with Jenny leveraging a performance-based incentive, there's a stronger focus on effectively managing and boosting the total endorsement revenue for greater returns. Both Jenny, as the agent, and Sara, the principal, are better aligned under a system where endorsement management directly influences their respective incomes.

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Most popular questions from this chapter

In the 1960 s, Yale University began offering students an alternative to taking out student loans. Instead, students could attend Yale in exchange for a specified percentage of their earnings over a significant length of time. Yale used historical data to determine the percentage so that the program would pay for itself - large payments from high earners would offset the smaller payments from low earners. a. If you were planning on becoming a Wall Street financier, would you be more likely to take out loans or enroll in the Yale program? Why? b. If you were planning on becoming a missionary, would you be more likely to take out loans or enroll in the Yale program? Why? c. The tuition program turned out to be a financial disaster for Yale. Do your answers to (a) and (b) shed light on why? Explain. d. What kind of information problem did the Yale program suffer from?

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