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Aditi Memani Spring 2012 Organizations Homework Homework #5 1. (BSZ1514). Susan Jones is a salesperson at Radex Co.

Her utility function can be represented by U = C2 where C is her compensation. a. The company is considering paying her a sales commission rather than a straight salary. The sales manager, however, is concerned that he will have to pay her a compensating differential for imposing risk on her that is beyond her control (sales at Radex are heavily dependent on macroeconomic factors and central company policies). Is the sales managers concern about paying Susan higher compensation justified? Explain. (7 points) The sales manager's concern is not justified. Susan is risk-loving therefore Radex would actually have to pay a compensating differential if the company chose to give Susan a straight salary. b. Is this example representative of the typical worker in most companies? Explain. (3 points) This is not a typical situation. Employees tend to be risk-averse instead of risk loving. 2. Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. She has an effort cost of C = e2 and a reservation wage of $1,500 so that wage package is W = 1500 +.2Q where Q (Mary Sues output) = 200 e. Here effort is known only by the employee. There is a random shock to output each period whose mean is zero. (a) What is the optimal effort for Mary Sue Nelson? (4 points) The optimal effort is where the cost curve is tangent to the slope of the compensation line. The cost curve is C=e2 and the compensation is W = 1500 +.2(200e). Therefore 2e = 40 and e* = 20. (b) On average, what total wage or salary will she earn each month? (2 points) On average her total wage per month will be $2,300.

(c) On average, what is the output of sales contracts that she makes? (2 points) On average the output of sales will be $4,000. (d) On average, what kind of profit will the CEO earn off of Nelson's work? (2 points) The profit will be the amount of her output minus the wage she will earn per month, therefore the profit will be $1,700. 3. (BSZ 1512.) In 1995, Philip Morris Company ratified a new labor pact that gave employees stock in lieu of pay increases. The agreement covered 7,800 employees, with each employee being given 94 shares (1994 value of about $60 per share). Employees cannot sell the stock for at least a year and forfeit the stock if they quit or are fired before the year expires. Business Week argued that the deal was good for Philip Morris because the employees' base pay and fringe benefits did not rise. Also current shareholders' shares won't be diluted, since employees probably will get less than 500,000 shares out of 850 million outstanding. Discuss the pros and cons of this policy compared to a policy of simply giving a cash bonus to employees of a similar dollar value. (10 points) There are many pros and cons to this agreement for compensation. Let's first look at the pros of this agreement. Since this agreement is an incentive compensation it will force the employees to perform better because that is the way the stocks could rise. Also this will force employees to focus on the big picture of the company and how they effect the big picture. Another reason the employees are forced to perform better is if they lose their job or have to quit they will lose their stocks and in the end lose a lot of money since their salary now includes stocks. Now that we have looked at the pros let's look at the cons of the situation. The first is that even though employees are forced to look at the big picture of the company, these employees do not have as many responsibility as employees higher up and do not believe that their work will actually effect the stock price. Also these employees get the stock at $60 while if the stock was sold in the market the price could increase dramatically depending on how high the demand. Therefore it would make more sense to sell the stock to a larger audience instead of just the employees.