Q2. The profit of the firm depends on effort of the agent e and a random component (economic conditions) e. The profit of the firm is π = e + 0.5€. The principal observes the profit, but does not know effort e. The only available information about economic shock for the principal is that E€ = 0. The principal maximizes his utility which is up (π, w) = E(T -w), where w is wage paid to the agent. The agent maximizes ua (w, e) = E(w) - c(e), where c(e) are costs of putting effort e. Suppose that c(e) = 0.5e². (a) Suppose that the principal observes effort. Design the first best contract. (b) Suppose now that effort is unobservable. Consider only linear contracts. Design the second best contract. Discuss the intuition of your results.

Q2. The profit of the firm depends on effort of the agent e and a random component (economic conditions) e. The profit of the firm is π = e + 0.5€. The principal observes the profit, but does not know effort e. The only available information about economic shock for the principal is that E€ = 0. The principal maximizes his utility which is up (π, w) = E(T -w), where w is wage paid to the agent. The agent maximizes ua (w, e) = E(w) - c(e), where c(e) are costs of putting effort e. Suppose that c(e) = 0.5e². (a) Suppose that the principal observes effort. Design the first best contract. (b) Suppose now that effort is unobservable. Consider only linear contracts. Design the second best contract. Discuss the intuition of your results.

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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