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ECO 550 Operations Decisions




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Eco 550 Week 1 Chapters 1 and 2 Answers
2. Explain several dimensions of the shareholder-principal conflict with manager-agents known as the
principal-agent problem. To mitigate agency problems between senior executives and shareholders,
should the compensation committee of the board devote more to executive salary and bonus (cash
compensation) or more to long-term incentives? Why? What role does each type of pay play in
motivating managers?
3. Corporate profitability declined by 20 percent from 2008 to 2009. What performance percentage
would you use to trigger executive bonuses for that year? Why? What issues would arise with hiring
and retaining the best managers?
6. In the context of the shareholder wealth-maximization model of a firm, what is the expected impact
of each of the following events on the value of the firm? Explain why.
Chapter 2: Exercises 1, 5, and 6
1. For each of the determinants of demand in Equation 2.1, identify an example illustrating the effect
on the demand for
2. Dimensions of principal agent problem
Principal-agent problem is concerned on challenges that arise when an
agent is required to act in the best interest of the principal. These
relationships can arise either through obligatory contractual relationships
or through informal relationships that are revealed at some point in time.
This problem arises when there is asymmetric information or as a result
of different interests between the two parties.
One problem managers face is keeping a company profitable as well as
increasing the value of shareholders dividends. The agent might have
hidden information which determines the level of their benefits and also
the benefit of the principal in which none of them could get in the
absence of the relationship. The agent has special skills in respective
areas of work with which the principal use for their interests. In this case
it’s extremely hard to monitor the steps taken by the agent to execute
his/her duties since this might lower their performance as a felling of
mistrust from the principal. Mutual consent is of great importance in this
kind of relationship.
The principal on the other hand might not have disclosed to the agent
the challenges faced in pursuit of their goal. The investment on its own
involves taking a risk with which expected returns are not certain. This
calls for initiating incentives to the agents to maximize the chances of
attaining these set targets.

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To deal with agency problems, managers should strike a balance
between the amount of earnings to be distributed to shareholders and
the amount to be retained in the firm for growth purposes. Policies
should be put in place which looks at both sides of concerns.
The compensation committee of the board should integrate a short term
and a long term remuneration measures to encourage the agents
achieve higher targets through cash compensation and better working
This is because of the need to have greater returns in every financial
year and make the managers’ part of the companies’ success.
Additional executive salary and bonus facilitates immediate rise of
companies’ profitability and extra work efforts in their pursuit of imminent
On the other hand, long-term incentives ensure efficient policies are put
in place thus leading to the growth and stability of the companies’
3. Issues arising from hiring and retaining best managers.
a) There would be new ideas generated to the firm thus leading to better
chances of higher returns. This therefore adds the value of the firm
making it stand a better competing chance.
b) Preserves organizational harmony by avoiding problems associated
with existing employees. It would thus be easier to project the firms’
profits in the near future.
c) Competitive intelligence is acquired through learning the firm thus
cutting down cases of losses. In this case learning effects would boost
the efficiency in the firm and lower operation costs.
d) Helps develop a different approach towards the market and marketing
products. This helps in learning the market trends and thus the firm can
come up with strategies that can widen market coverage.
e) It acts as a motivational tool hence more productivity and growth in
the organization because they feel that they are stakeholders.

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