Problem Set #3

ECON 3960

1. The value of the project if it succeeds is $1 million; the probability of success given high
effort is 0.5; the probability of success given low effort is 0.25. The utility of the manager
is u(w) = √w where w is the wage (in millions of dollars) and his disutility from exerting
high effort is 0.1. However, now, the reservation wage (outside option) is $160,000.

(a) What contract does the company offer if it wants only low effort from the
manager? What is the expected profit to the company in this case?

If the company wants only low effort from the manager, it offers a contract for a
wage that maximizes the following utility problem (with √ x set to X and √ y set to Y:

1
x , y max ( 1−Y 2 ) + 3 (0− X 2)
4 4
1 3
s . t . Y + X ≥ √ 0.16( PC)
4 4
1 3 1 1 1 1
Y + X ≥ Y + X −0.1 → X − Y +0.1 ≥0 ( IC)
4 4 2 2 4 4

1 3 1 3 1 1
4 4 [ 4 ]
L= ( 1−Y 2 ) + ( 0− X 2 ) + μ1 Y + X−√ 0.16 + μ 2 [ X− Y +0.1]
4 4 4

[ X ] :−1.5 X + 3 μ1 + 1 μ2=0
4 4
1 1 1
[ Y ] :− Y + μ − μ2=0 → μ1=μ2 +2 Y
2 4 1 4

Plugging [Y] equality into [X]: 6 X =4 μ 2+ 6Y → μ2=1.5 ( X −Y )> 0, so IC is

binding…

 Using the IC equality: Y = X +0.4

 Plugging this into PC: 4 X +0.4=1.6 → X=0.3 ,Y =0.7 →

X =0.548 , Y =0.837; in millions of dollars

Expected profit of the company with induced low effort:

1 3
( 0.3 ) + (−0.3 ) =−1.5=−1.5 million dollars
4 4
 (b) What contract pair (y,x), where y is the salary given for a successful project and x
is the salary for a failed project, should the company offer the manager to induce
high effort? What is the expected profit to the company in this case?

If the company wants to induce high effort from the manager, it offers a contract
for a wage that maximizes the following utility problem:

1 1
x , y max ( 1−Y 2 ) + ( 0−X 2)
2 2
s . t . 0.5Y + 0.5 X−0.1 ≥ √ 0.16 (PC )
1 1 1 3 1 1
Y + X−0.1≥ Y + X → Y − X−0.1 ≥ 0( IC )
2 2 4 4 4 4

Using the IC equality: Y = X +0.4

 Plugging this result into PC: 2 X +0.4−0.2=0.8 → X =0.3 , Y =0.7 →

X =0.548 , Y =0.837; in millions of dollars

Expected profit of the company with induced high effort:

1 1
( 0.3 ) + (−0.3 ) =0
2 2

(c) Which level of effort would the company want to induce from its manager? Why?
The company would want to induce a high effort level from its manager, because
the expected profit at this level is higher than expected profit at low effort.

2.
Suppose that 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 agents 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 principals payoff is 20−ws, in case of
success, and 4−wf , in case of failure.
Assume that the principals payoff is she does not invest in the project is zero. If the agent
gets paid w, then his payoff is given by lnw−φ, where φ = ln4 if he puts in high effort;
and, φ = 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

(a) Optimal contract that induces high effort is obtained through the principal’s utility
maximization problem:
w s , w f max 0.75 ( 20−ws ) + 0.25 ( 4−w f ) −I
s . t . 0.75 ln ws + 0.25 ln wf −ln 4 ≥ 0(PC )
0.75 ln w s +0.25 ln w f −ln 4 ≥ 0.25 ln w s +0.75 ln w f
→ 0.5 ln w s−0.5 ln w f −ln 4 ≥ 0(IC )

This is optimized with the Lagrangean:

L=0.75 ( 20−w s ) +0.25 ( 4−w f ) −I + μ1 [ 0.75 ln w s+ 0.25 ln w f −ln 4 ]+ μ 2 [ 0.5 ln w s−0.5 ln wf −ln 4 ]

Taking the first-order conditions gives:

0.25 μ 1 0.5 μ2
[w f ¿ :−0.25+ − =0
wf wf
0.75 μ1 0.5 μ2
[w s ¿ :−0.75+ + =0
ws ws

μ 1 2 μ2
 [w f ¿ : − =1→ μ1=wf + 2 μ2
wf wf
0.75 w f +1.5 μ 2 0.5 μ 2
 Plug into [w s ¿ : + =0.75→ 3 w f +8 μ2=3 ws
ws ws
3
→ μ 2= ( ws −w f ) >0 , which means that the incentive compatibility constraint is
8
binding. The participation constraint is also binding due to μ1 > 0 in [w f ¿; therefore
IC and PC can be used as equalities to solve for the contracts:

1
 w f = ; w s=8
2
(b) Optimal contract that induces low effort:

w s , w f max 0.25 ( 20−ws ) + 0.75 ( 4−w f ) −I

s . t . 0.25 ln ws + 0.75 ln wf ≥ 0( PC )
0.25 ln w s +0.75 ln w f ≥ 0.75 ln w s+ 0.25 ln w f −ln 4
→ 0.5 ln w f −0.5 ln ws + ln 4 ≥ 0(IC )

The PC and IC can be used again as equalities in solving for the contracts:

From PC: 0.25 ln w s +0.75 ln w f =0; the only way this is possible is if both w s and w f

equal 1 so that the natural logs are equal to 0. Therefore, w s=wf =1

(c) The expected profit determines which contract is optimal:

E [ π h ] : 0.75 ( 12 ) +0.25 ( 3.5 )−I =9.875−I

E [ π l ] :0.25 ( 19 ) +0.75 ( 3 ) −I =7−I

Expected profit with high effort is higher, so inducing high effort is optimal.

(d) The range of I that determines whether the principal hires the agent, when high effort
is assumed to be optimal, is simply I ≤ 9.875, where expected profit remains ≥ 0.

(e) What about if the principal could observe and contract on effort?

If the principal can observe effort, then the incentive compatibility constraint is not
binding. Therefore, the principal’s utility maximization problem becomes:

w s , w f max 0.75 ( 20−ws ) + 0.25 ( 4−w f ) −I

s . t . 0.75 ln ws + 0.25 ln wf −ln 4 ≥ 0(PC )

 The Lagrangean is taken to optimize the utility function:
L=0.75 ( 20−w s ) +0.25 ( 4−w f ) −I + μ [0.75 ln w s +0.25 ln w f −ln 4 ]

0.25 μ
[ w f ] :−0.25+ wf
=0

0.75 μ
[ w s ] :−0.75+ w =0
s

Therefore μ=w f =ws >0 , making the participation constraint hold with equality.
Then, the PC can be used to solve for the optimal contract:

lnw s=ln 4 → w s=wf =4

The expected profit of the principal with induced high effort then becomes
0.75 ( 16 ) +0.25 ( 0 ) −I, so observable effort makes the hiring range of I:

I ≤ 12

3.
(a) The optimal contract that induces high effort is solved with the following problem of
the principal:

t h ,t l max p h ( q h−t h ) +(1− ph )(ql −¿ t l )¿

s.t. ph t h +(1− p¿¿ h) t l −c ≥ 0 ¿ (PC)
ph t h +(1− p¿¿ h)t l −c ≥ pl t l +(1− p¿¿ l) t h ¿ ¿ (IC)
th≥ 0 (LLh)
tl≥ 0 (LLL)

The incentive compatibility restraint can be written as ( ph− p ¿ ¿l)(t h−t l)≥ 0 ¿, which
implies that the high transfer > low transfer, so LLh can be ignored, since assuming LLL
implies LLh. Test to see which of PC or LLL binds/holds with equality:

ph t h +(1− p¿¿ h)t l =c ¿

c−( 1− p¿¿ h)t l

Sub this into the IC constraint t h= ¿
ph
 c−(1− ph )t l
 ( ph− p ¿ ¿l) ( ph )
−t l −c ¿

p h − pl −t ( p − p ) p
 ( c−t l ) −c  l h l − l c, which is < 0…therefore, the participation
ph ph ph
constraint does not bind.

Since LLL is binding, t l=0, and IC is implied to be binding:

c
ph t h −c=(1− p¿¿ l)t h ¿  t h=
p h − pl

(b) The optimal contract that induces low effort is the solution to the following
principal’s problem:

t h ,t l max pl ( q h−t h ) +(1− pl )( ql −¿ t l )¿

s.t. pl t l +(1− p¿¿ l) t h ≥ 0 ¿ (PC)
pl t l +(1− p¿¿ l)t h ≥ ph t h +(1− p¿¿ h)t l−c ¿ ¿ (IC)
th≥ 0 (LLh)
tl≥ 0 (LLL)

The only solution that satisfies the incentive compatibility constraint, since t h cannot be
less than t l, would be where t h=t l. Therefore, t h=t l=0

c
(
(c) E [ π h ]= ph qh−
ph− pl )
+ ( 1− ph ) ( q l−0 )

E [ π l ]= pl qh +(1− pl )ql

High effort is optimal, because the expected benefit of high effort exceeds the
ph
expected cost: ( ph −p l )( qh −ql ) ≥ c
ph −p l

(d) With observable effort, the incentive compatibility constraint becomes unnecessary.
Assuming high effort is optimal:
 t h ,t l max p h ( q h−t h ) +(1− ph )(ql −¿ t l )¿
s.t. ph t h +(1− p¿¿ h) t l −c ≥ 0 ¿ (PC)
t h≥ 0 (LLh)
tl≥ 0 (LLL)

PC must be binding, because otherwise the principal could decrease the transfer and
increase profit:
ph t h +(1− p¿¿ h)t l =c ¿

Monitoring, then, is optimal if the expected profit with monitoring (w) is greater than
the expected profit without it:
c
ph qh + ( 1− ph ) ql −c−w ≥ ph qh−( ph− pl )
+(1− p h)ql

 Solving for w results in the viable range monitoring costs:

ph
w≤ c
p h− pl

(e) Without the limited liability constraints, the landlord’s problem becomes:

t h ,t l max p h ( q h−t h ) +(1− ph )(ql −¿ t l )¿

s.t. ph t h +(1− p¿¿ h) t l −c ≥ 0 ¿ (PC)
ph t h +(1− p¿¿ h)t l −c ≥ pl t l +(1− p¿¿ l) t h ¿ ¿ ( ph− pl ¿ ( t h−t l )−c ≥ 0 (IC)

The participation constraint must bind, because otherwise the transfers could be
decreased in order to increase the landlord’s profit. Then, this first equality can be
substituted into the expected profit formula:

ph t h + ( 1−p h ) t l −c=0
 ph qh + ( 1− ph ) ql −c

Finally, this becomes the following equation with the tenant’s constraints:
ph
ph qh + ( 1− ph ) ql − c
ph −p l
 The landlord’s profit is lower than in (a), so the landlord is better off when the tenant
is not constrained.

4. Consider a managerial effort example similar to the one in Question 1. Now, the value of
a successful project is $420,000; the probabilities of success are 0.5 with good
supervision (high effort) and 0.25 without, respectively. However, the manager is risk
neutral, not risk averse this time. Therefore, his expected utility equals his expected
income minus his disutility of effort (in other words, he has a linear utility function). His
reservation utility (outside option) is $90,000 and his disutility for exerting high effort is
$100,000.

(a) Show that inducing high effort requires the principal to offer a compensation scheme with
a negative base salary:
1 1
x , y max (0.42− y)+ (0−x )
2 2
s . t . 0.5 y + 0.5 x−0.1≥ 0.09( PC)
1 1 1 3 1 1
y + x−0.1 ≥ y + x → y− x−0.1 ≥ 0( IC)
2 2 4 4 4 4

The Lagrangean:

1 1 1 1
2 2 4[
L= ( 0.42− y )+ ( 0−x ) + μ1 [ 0.5 y +0.5 x−0.19 ] + μ2 y− x−0.1
4 ]
[ y ] : 1 y + 1 μ1 + 1 μ 2
2 2 4
1 1 1
[ x ] :− x+ μ1− μ2 → μ 2=2 μ1 −2 x , so IC holds with equality with a negative value of x
2 2 4

 y=x +0.4 ; plugging this into PC results∈: x=−0.01 , y=0.39

(b) How might a negative base salary be implemented in reality?

In reality, a negative base salary could be implemented by having an employee pay a

daily fee when entering their place of work; perhaps, the employee must swipe their
credit card at the door, or swipe their credit card in order to access their desk/work station
 for the day. This would effectively make the employee’s base pay negative, and putting
in effort would result in a positive compensation.

(c) Show that if a negative base salary is not feasible (i.e. there is limited liability), then the
principal is better off with the low-pay, low-effort situation.

If there is limited liability, then x must be 0 at the lowest. So, expected profit at high
effort is then:
1
( 0.03 )=0.015 million dollars
2

At low effort, the principal’s problem is:

1 3
x , y max (0.42− y )+ (0−x )
4 4
s . t . 0.25 y + 0.75 x ≥0.09 (PC )
1 3 1 1 1 1
y + x ≥ y+ x−0.1→− y + x +0.1 ≥ 0(IC)
4 4 2 2 4 4

To induce low pay without violating the limited liability constraints, x = 0, and using PC:
y=0.36
Expected profit in this case is 0.25(0.42 - 0.36) = 0.015, making the principal indifferent,
likely to opt for low effort.