Problem Set 3 Microeconomics II - Spring Semester 2011 Due date: 19/04/2011 1a). MWG 14.B.3.

[In part (c) of the question, it should be " ......do changes in

2

and

: " ]. 1b). MWG 14.B.4 2. MWG 14.C.3 3. Consider a standard principal agent model with hidden action. The principal who

maximizes her expected prots wants to hire an agent. If the agent puts high eort (eH ), output level (xH ) = 20 can occur with 0:6 probablity and (xL ) = 1 can be observed with the remaining probablity. Instead, if the agent puts low eort (eL ), output level (xH ) = 20 is observed with 0:4 probablity and (xL ) = 1 can be observed with the remaining probablity. Assume that the utility of the agent is u(w) = w 3
1

c(e) where w is the wage the agent

receives and c(e) is the eort cost when the agent takes action e. Assume that c(eH ) = 0:2 and for c(eL ) = 0 and the reservation utility of the agent is 0:5. a) Assume that the principal can observe the eort of the agent. i) Suppose that the principal wants to implement high eort level eH . Calculate the expected prot of the principal. ii) Suppose that the principal wants to implement low eort level eL . Calculate the expected prot of the principal. Compare the prots in (i) and (ii). Which one should be chosen by the principal? b) Now consider the hidden action scenario. The wages are now the functions of output produced - when x = xH , the wage is wH and when x = xL , the wage is wL . Suppose that the principal wants to implement eH . What is the condition (inequality) that guarantees that the agent indeed prefers action eH over eL ? Also write down the condition under which the agent prefers the contract oered to the reservation utility 0.5. Brie discuss why these y two inequalities are satised with the equality. 1

c) Find out optimal wH and wL : If the principal wants to implement the high eort, what is her prot ? d) Suppose the principal wants the agent to take the low eort eL . The principal in this case will oer a common (or wage w (deviating to high eort is more costly so this at) problem is gone!!). Write down the individual rationality constraint here when she takes the action eL . Set the constraint to equality (why?) and calculate the equilibrium wage (just using this constraint-you don need anything else!). Also calculate the prot of the principal t if she wants to implement low eort under this hidden action. e) Under this hidden action problem, which contract does the prinicial want to implement. f) Do you agree that under both the situations (observability and hidden action) the principal chooses the same action? Then why the prot of the principal varies in two dierent situations? g) If the principal can aord a watch dog which can perfectly monitor (and therefore the principal can implement the full observability contract) the actions, calculate her willingness to pay for it? h) Calculate the utility of the agent under the two difefrent cases (under fully observable and under the hidden action). 4. Show that with two probable outcomes, monotone likelihood ratio property and FOSD are equivalent. Also show that in general this equivalence does not hold.