University of Nottingham

School of Economics

L14001
Microeconomic Theory
MSc

Tutorial II.1 Exercises

Solutions
Questions 1 and 2 are based partly on the example in Kreps, D.M. (1990) A Course in
Microeconomic Theory, FT Prentice Hall, pp. 601-602.

1. Consider the following principal-agent situation. Agent’s utility from wage w ≥ 0

√
is u(w) = + w (the positive square root of w) and agent’s disutility from effort a is
d(a) = a. There are two profit levels, πl = £0 and πh = £100. Suppose that there
are two levels of effort that the agent can take, a1 = 1 and a2 = 2. The probabilities
of high profit after these effort levels are p1,h = 0.4 and p2,h = 0.6. The principal
offers the agent contracts that the agent can accept or reject. If the agent accepts the
contract, the agent chooses effort. Agent’s payoff is the expected utility E[u(w)]−d(a)
and principal’s payoff is the expected net profit E[π] − E[w]. If the agent rejects, the
agent gets the reservation utility uo = 1 and principal’s payoff is 0.
(a) Suppose that effort is observable and contracts are (w1 , w2 ), where w1 is the
wage paid after low effort and w2 is the wage paid after high effort. What is the
optimal contract for the principal?
(b) Suppose now that effort is not observable and contracts are (wl , wh ), where wl
is the wage paid after low profit and wh is the wage paid after high profit. What is
the minimal expected cost for the principal to induce the agent to take a2 ?
(c) Find the optimal contract for the principal if effort is not observable.

Solutions:
(a) The benefits from the two actions to the principal are B1 = 0.4·100 = 40, B2 =
0.6 · 100 = 60. If the effort is observable, the principal takes into account only the
participation constraint. The cost of given action ai is Ci = u−1 (uo + d(ai )), where
√
u−1 is the inverse of utility from wages u(w) = + w and d(a) = a is the disutility of
effort. The cost of implementing effort a1 is then C1 = (1 + 1)2 = 4 and that of effort
a2 is C2 = (1 + 2)2 = 9. Then B1 − C1 = 40 − 4 = 36 and B2 − C2 = 60 − 9 = 51.
Therefore the optimal contract if actions are observable is to implement effort a2 by
offering w2 = 9, and w1 ≤ 4.

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 Answer: The optimal contract is to implement a2 with w2 = 9 and w1 ≤ 4.
(b) If effort is not observable, to find the minimal cost of implementing effort a2 ,
note that p1,l = 1 − p1,h = 0.6, p2,l = 1 − p2,h = 0.4. The principal solves

min 0.6wh + 0.4wl

wl ,wh
√ √
s.t. 0.6 wh + 0.4 wl − 2 ≥ 1
√ √ √ √
0.6 wh + 0.4 wl − 2 ≥ 0.4 wh + 0.6 wl − 1

(and constraints wl ≥ 0, wh ≥ 0, which will be ignored for the moment). This

constrained optimisation problem can be solved in many ways. For example, the fol-
lowing reasoning can be used. The first, participation, constraint is binding because
otherwise wages can be reduced a bit still keeping the constraints satisfied. The in-
centive compatibility constraint is binding because of the following reasoning. First,
wh > wl because otherwise the agent prefers lower effort. If the incentive compati-
bility constraint is not binding, the principal can decrease wh a bit, increase wl a bit
(keeping the participation constraint binding) still keeping the incentive compatibil-
ity constraint satisfied. Since the agent is risk-averse, the agent prefers a smaller gap
between wages. The expected wage to make the agent accept a smaller gap is then
lower, so the principal can reduce his cost. Therefore such wh , wl that do not bind
the incentive compatibility constraint cannot be optimal.
If the two constraints are binding, there is a system of two equations
√ √
0.6 wh + 0.4 wl − 2 = 1
√ √ √ √
0.6 wh + 0.4 wl − 2 = 0.4 wh + 0.6 wl − 1
√ √
The first equation is 0.6 wh +0.4 wl = 3. Substituting this into the second equation,
√ √ √ √ √
0.4 wh + 0.6 wl = 2. Adding up the two equations, wl + wh = 5, or wl =
√ √ √
5 − wh . Substituting into the first equation, 0.6 wh + 0.4(5 − wh ) = 3, or
√ √ √ √
2 + 0.2 wh = 3, or 0.2 wh = 1, or wh = 5 thus wh = 25. Then wl = 5 − 5 = 0
and wl = 0. The expected cost of inducing effort a2 is C(a2 ) = 0.4 · 0 + 0.6 · 25 = 15.
Answer: The minimal expected cost to induce a2 is C(a2 ) = 15.
(c) The optimal cost to induce the lowest action a1 was found in (a) and is C(a1 ) =
C1 = 4. The benefits were also found in (a), B1 = 40, B2 = 60. Since the net benefit
B2 − C(a2 ) = 60 − 15 = 45 > B1 − C1 = 36, it is optimal for the principal to induce
a2 with contract wl = 0, wh = 25.
Answer: The optimal contract is wl = 0, wh = 25.

2. Suppose now that in the situation described in Question 1, there is also a third
level of effort available for the agent, a3 = 4. The probability of high profit after this
effort level is p3,h = 0.8. The rest of the parameters are the same as in Question 1.
(a) What is the optimal contract for the principal if effort is observable?

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 (b) Find the minimal expected cost to induce a3 if effort is not observable.
(c) What effort does the principal want to induce if effort is not observable? What
is the optimal contract for the principal?

Solutions:
(a) The benefit to the principal from a3 is B3 = 0.8 · 100 = 80. If the effort
is observable, the cost of a given action ai is Ci = u−1 (uo + d(ai )). The cost of
implementing effort a3 is then C3 = (1 + 4)2 = 25. Then B3 − C3 = 80 − 25 = 55.
Since B1 − C1 = 36 and B2 − C2 = 51 from Q1(a), the optimal contract is to
implement a3 with w3 = 25 and w1 ≤ 4, w2 ≤ 9. (Note that there are three levels of
wages because the principal observes three levels of effort.)
Answer: The optimal contract is to implement a3 with w3 = 25 and w1 ≤ 4,
w2 ≤ 9.
(b) The minimal cost to induce a2 was found in Q1(b) because the addition of
a higher action a3 does not change the solution of the cost minimisation problem
for the principal. Indeed, the incentive constraint for taking a2 rather than a3 is
√ √ √ √
0.6 wh + 0.4 wl − 2 ≥ 0.8 wh + 0.2 wl − 4. At the solution of Q1(b), wl = 0,
wh = 25, the constraint is satisfied: 0.6 · 5 − 2 = 1 > 0.8 · 5 − 4 = 0. Thus the incentive
constraint for the higher effort a3 is not relevant for the solution for a2 .
To find the minimal cost to induce effort a3 , the principal solves

min 0.8wh + 0.2wl

wl ,wh
√ √
s.t. 0.8 wh + 0.2 wl − 4 ≥ 1
√ √ √ √
0.8 wh + 0.2 wl − 4 ≥ 0.4 wh + 0.6 wl − 1
√ √ √ √
0.8 wh + 0.2 wl − 4 ≥ 0.6 wh + 0.4 wl − 2

The participation constraint should be binding, otherwise wages can be reduced. Also
one of the incentive compatibility constraints should be binding, but apriori it is not
clear which one. Rewrite the incentive constraints as
√ √
0.4( wh − wl ) ≥ 3
√ √
0.2( wh − wl ) ≥ 2

or as
√ √ 3
wh − wl ≥ = 7.5
0.4
√ √ 2
wh − wl ≥ = 10
0.2
Then it is clear that if the second constraint is satisfied, then the first constraint is
also satisfied. Thus the first constraint is redundant and can be ignored. Thus only
the second incentive compatibility constraint can be relevant and binding.

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 With the binding constraints, the system of two equations is
√ √
0.8 wh + 0.2 wl − 4 = 1
√ √
wh − wl = 10
√ √
From the second equation wh = 10 + wl . Substituting into the first equation,
√ √ √
8 + wl = 5, or wl = −3. Oops! + wl cannot be negative. Here the limited
√ √
liability constraints wl ≥ 0, wh ≥ 0 (and thus + wl ≥ 0, + wh ≥ 0) kick in. Taking
them into account, the solution then has wl = 0, as the principal wants to give the
agent as low wage wl as possible. The participation constraint is not binding anymore
√
but the incentive compatibility one still is. Then wh = 10. Note that the other
incentive compatibility constraint is then 0.8 · 10 − 4 = 4 ≥ 0.4 · 10 − 1 = 3, which is
satisfied. For the participation constraint, 0.8 · 10 − 4 = 4 ≥ 1, which is also satisfied.
The expected cost of inducing a3 is therefore C(a3 ) = 0.8 · 102 = 80.
[An alternative way to solve the problem is to try each of the incentive constraints
√ √
be binding in turn, solve for wl , wh and substitute into the other constraint. You
√ √
will find that making the first constraint binding leads to wl , wh that do not satisfy
the second constraint.]
Answer: The minimal expected cost to induce a3 is C(a3 ) = 80.
(c) To find the optimal contract, one needs to find the minimal cost to induce
each action. Effort a1 can be induced by a flat wage and the cost was found in Q1(a),
C(a1 ) = 4. The cost to induce a2 was found in Q1(b), C(a2 ) = 15. Gross benefits Bi
for the principal were found in Q1(a) and Q2(a). Since B1 − C(a1 ) = 40 − 4 = 36,
B2 − C(a2 ) = 60 − 15 = 45, and B3 − C(a3 ) = 80 − 80 = 0, it is optimal for the
principal to induce effort a2 with contract wl = 0, wh = 25. The expected profit of the
√
principal is B2 − C(a2 ) = 45, and the expected utility of the agent is 0.6 · 25 − 2 = 1.
Answer: The principal wants to induce a2 . The optimal contract is wl = 0, wh =
25.

3. Consider the following principal-agent situation. Suppose that the agent can
choose effort levels from the interval [0, 1]. Given effort a, the profit of the principal
is πh = 1 with probability ph = a and πl = 0 with probability 1 − a. The principal
does not observe effort but observes profit. The principal offers the agent a contract
(wl , wh ), where wl is the wage paid if πl is realised and wh is the wage paid if πh
is realised. The agent can accept or reject the contract. If the agent accepts the
contract, the agent chooses effort. Agent’s utility function from wages is u(w) = w
and the disutility function from effort is d(a) = a2 , thus the agent’s payoff from a
contract is E[w] − d(a), where E[w] is the expected wage. The principal’s payoff from
a contract is E[π] − E[w], where E[π] is the expected profit. If the agent rejects, the
payoffs for both the agent and the principal are 0.
(a) Find the minimal expected cost for the principal to induce any given effort a.
What is this expected cost for a = 21 ?

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 (b) What effort does the principal want to induce? What is the optimal contract
for the principal?
(c) Discuss the properties of the optimal contract. How much does the principal
lose in this situation because of moral hazard?

Solutions:
(a) In the case of continuous action, the cost minimisation problem for action a
for the principal is

min awh + (1 − a)wl

wl ,wh

s.t. awh + (1 − a)wl − a2 ≥ 0

a maximises U (a) = awh + (1 − a)wl − a2

The first order approach is justified since U (a) is concave. The last constraint can be
replaced by the first order condition dUda(a) = 0, or wh − wl = 2a, provided that wh , wl
are such that a = wh −w
2
l
∈ [0, 1]. This will be the case because if wh −wl > 2, the agent
will choose a = 1 and this can be also achieved with lower wh thus cannot be optimal.
Similarly, if wh − wl < 0, the agent will choose a = 0 which can be achieved also with
lower wl thus not optimal. Thus wh = wl + 2a. Since the participation constraint is
binding, then (1 − a)wl + awl + 2a2 − a2 = 0, or wl = −a2 . Then wh = 2a − a2 . The
expected cost of inducing action a is then C(a) = (1 − a)(−a2 ) + a(2a − a2 ) = a2 .
For a = 21 , the cost is 14 .
Answer: The minimal expected cost to implement action a is a2 . For a = 21 , the
cost is 14 .
(b) The gross benefit to the principal from action a is B(a) = (1 − a) · 0 + a · 1 = a.
The net benefit B(a) − C(a) = a − a2 . The first order condition for maximisation
is 1 − 2a = 0 and thus a = 21 (the second order condition for global maximum is
satisfied). Thus the principal wants to induce a = 12 with contract wl = −a2 = − 14 ,
wh = 2a − a2 = 43 .
Answer: The principal wants to induce a = 12 . The optimal contract is wl = − 14 ,
wh = 34 .
(c) Observe that the expected payoff to the principal is (1 − a)(πl − wl ) + a(πh −
wh ) = (1 − a)(0 − (− 41 )) + a(1 − 43 ) = (1 − a) 14 + a 14 = 14 . The principal gets 41
independently of what profit is realised. The contract is a franchising contract, which
shifts all the uncertainty to the agent. This is optimal because the agent is risk-
neutral with respect to wages and thus with respect to uncertainty associated with
them.
If there was no moral hazard and the principal could observe effort, to induce effort
a the principal would, because of the participation constraint, offer wages w(a)−a2 =
0, or w(a) = a2 . Note that it is the same as the cost to implement action a in (a).

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Therefore the principal does not lose anything because of moral hazard, which is a
general case if the agent is risk-neutral.
Answer: One can observe that the optimal contract is a franchising contract.
The principal does not lose anything because of moral hazard.