Question

The owner of a thriving business wants to open a new office in a distant city. If he can hire someone who will manage the new office honestly, he can afford to pay that person a weekly salary of $2,000 ($1,000 more than the manager would be able to earn elsewhere) and still earn an economic profit of $800. The owner’s concern is that he will not be able to monitor the manager’s behavior and that the manager would therefore be in a position to embezzle money from the business. The owner knows that if the remote office is managed dishonestly, the manager can earn $31,00 while cusing the owner an economic loss of $600 per week.

Required:

1. If the owner believes that all managers are narrowly self-interested income maximizers, will he open the new office?

Answer 1

From the decision tree in the attached file, it can be seen that the dominant strategy of manager is to be dishonest as it gives the highest payoffs. Knowing this owner should not open remote office because believing that everyone works to maximize his own payoffs, manager will always be dishonest.