ECON 432/532 - Economics of Information and Contracts

Sample Questions for Exam II

Levent Koçkesen Koç University

1. A risk neutral principal hires a risk averse agent to undertake a project, which has a fixed cost of I ≥ 0
for the principal. The project is either successful, in which case the value of the project for the principal
is 20, or it is a failure, in which case the value is 4. The agent chooses to put in either high or low effort.
If he puts in high effort, then the probability of success is 0.75, and if he chooses low effort, probability
of success is 0.25. The principal cannot observe the agent’s effort but observes whether the outcome is a
success or a failure. Therefore, feasible contracts are payments to the agent in case of success and failure,
i.e., (ws , wf ). Therefore, the principal’s payoff is 20 − ws , in case of success, and 4 − wf , in case of failure.
Assume that the principal’s payoff is she does not invest in the project is zero.
If the agent gets paid w, then his payoff is given by ln w − ψ, where ψ = ln 4, if he puts in high effort, and
ψ = 0, if he puts in low effort. Also assume that the reservation utility (i.e., the payoff he gets if he does
not accept the contract offer) of the agent is zero.
Note: You may assume that the Kuhn-Tucker conditions are necessary and sufficient to identify global
optimum.
Some facts about ln and e:
• limx→0 ln x = −∞
• ln e = 1, ln 4 > 0, a ln x = ln(xa ), ln a + ln b = ln(ab), eln x = x
d 1
• dx ln x = x

(a) What is the optimal contract that induces high effort?

(b) What is the optimal contract that induces low effort?
(c) What effort level is optimal to induce?
(d) Assume that it is optimal to induce high effort. For what range of I, the principal will find it optimal
to hire the agent? How about if the principal could observe and contract on effort?
(e) Prove that in part (a) Kuhn-Tucker first order conditions are necessary and sufficient for global
optimum.

2. A risk neutral landowner is going to offer a tenancy contract to a financially constrained tenant. The
crop yield is either high, qh , or low, ql , with qh > ql ≥ 0. The tenant chooses to put in either high or low
effort. If he puts in high effort, then the probability of high output is ph , and if he chooses low effort,
probability of high output is pl , with ph > pl > 0. The landlord cannot observe the tenant’s effort but
observes whether the output is low or high, and hence feasible contracts are transfers to the tenant in
case of high and low outputs, i.e., (th , tl ). Therefore, the landlord’s payoff is qh − th , if output is high,
and ql − tl , if output is low. If the tenant receives a transfer t and puts in high effort, then his payoff is
given by t − c, where c > 0 is the cost of high effort. If he chooses low effort, then his payoff is simply t.
The tenant has limited liability so that tl ≥ 0 and th ≥ 0. Also assume that the reservation utility (i.e.,
the payoff he gets if he does not accept the contract offer) of the tenant is zero.
(a) What is the optimal contract that induces high effort?
(b) What is the optimal contract that induces low effort?
(c) What effort level is optimal to induce?
(d) Assume that it is optimal to induce high effort. Suppose that at cost w > 0, the landlord can
monitor and learn with certainty whether the agent puts in high or low effort. For what range of w,
the landlord will find it optimal to monitor?
(e) Now suppose that there is a functioning credit market so that the there are no limited liability
constraints any more. Find the landlord’s expected profit under the optimal contract and compare
it with her expected profit from part (a).

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 3. Consider a risk neutral firm owner and her manager. Revenue generated by the manager is given by

R=e+x

where e ≥ 0 is the effort choice of the manager and x is a random variable with zero mean and variance
vx > 0. Expected payoff of the firm owner is given by

E[R − w]

where E is the expectation operator and w is the manager’s wage. Revenue is observable by the owner
but effort and x are not. Furthermore, wage contracts are limited to be linear, i.e.,

w = t + sR

Manager is risk averse and his expected payoff function is given by

r c
E[w] − var(w) − e2
2 2
where var(w) is the variance of the manager’s wage and r, c > 0. The manager’s best alternative to
working for this firm yields him an expected payoff of 0. The timing of the events is as follows: (1) Owner
offers a wage contract; (2) Manager accepts or rejects; (3) If he rejects, he receives 0 and owner receives
zero payoff; (4) If he accepts, he chooses effort level e; (5) x and R are realized and payoffs are received.

Note: Let a, b, c be constants and X and Y be two random variables with covariance cov(X, Y ). Then

E[c + aX + bY ] = c + aE[X] + bE[Y ]

var(c + aX + bY ) = a2 var(X) + b2 var(Y ) + 2ab cov(X, Y )

(a) What is the efficient effort level? (I.e., the effort level that maximizes the expected sum of the owner’s
and manager’s payoffs.)
(b) What is the optimal wage contract? What is the equilibrium effort level and how does it differ from
the efficient effort?
(c) Assume now that there is another observable random variable y (say, industry demand) with zero
mean and variance vy > 0. Let the covariance between x and y be vxy and the correlation coefficient
vxy
ρ= √
vx vy

Suppose the compensation contracts have to be in the form of

w = t + sR + by

where t, b, s are constants chosen by the owner. What is the optimal s and b? Under what conditions
is it optimal to choose b = 0? Interpret.

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