Problem
Curtis manages an electronics store in Wichita, Kansas. He considers carrying cameras from Nikon Americas with a U.S. warranty or gray market Nikon cameras from a European supplier, which are the same cameras, but their warranties are only good in Europe. The gray market cameras have a lower wholesale price. Curtis earns 10% of the store's profit (and no wage). If the store loses money, he leaves with nothing. He believes that if he sells the Nikon Americas cameras, the store's profit will be $400,000. The profit on the gray market cameras is more uncertain-will locals be willing to buy a less expensive camera without a warranty? If he sells the gray market cameras, he believes he has a 50% chance that the store's profit will be $1,000,000 and a 50% probability that the store will lose $300,000. Curtis and the store's owner are both risk-neutral.
i. Which camera does Curtis choose to sell? What choice would the owner prefer (if she were fully informed)?
ii. Construct an alternative compensation plan involving a salary such that Curtis will earn as much from selling Nikon Americas cameras as from selling gray market cameras. Such a compensation plan must dissuade him from selling gray market cameras if doing so lowers the owner's expected earnings.