Econ 2105 Economics of Corporations Suraj Prasad Session 2, 2010 Problem Set 2 This is a graded problem set.

The problem set is due on the 12th of August at the stat of the lecture (at 9 am). Note that the answers to this problem set will be discussed in the tutorials (prior to the answers being handed in) so be sure to attend them. 1. Consider a setting with a risk averse worker and a risk neutral rm. The worker exerts an eort level a which is unobservable to the rm and his eort cost is given by C (a) = ca2 . Total output is given by y = ka + where is a random variable with E ( ) = 0 and V ar( ) > 0. Firms oer workers a take it or leave it wage contract of the form w = s+by . Assume that the rm maximizes expected prots (E (y w)) and the worker maximizes his certainty equivalent given by CE = 1 E (w) rV ar(w) ca2 where r measures how risk averse a worker is. 2 The workers outside option is 0. (a) Compute E (y ), E (w), and V ar(w). (I went through this quickly in class and the board was messy as well. So hopefully writing these expressions and substituting them in the objective function and constraints will make things clear. If not I can discuss this at the start of Lecture 3.) (b) Set up the maximization problem (write down the objective function, constraints and choice variables) for a rm. (c) Compute the ecient level of eort. (To do this add the rms expected prot and the workers certainty equivalent and maximize with respect to eort.) (d) Compute the rms optimal choice of s, b, and a when c = 1, r = 1, k = 1, V ar( ) = 1. (e) Compute the rms optimal choice of s, b, and a when c = 1, r = 1, k = 1, V ar( ) = 2. Compare your answer to part 1(d) and provide a short (two sentence) explanation for why it is dierent. 1

(f) Are the eort levels from part 1(d) and part 1(e) above ecient. If not, provide a short (two sentence) explanation for why this is the case.