n Answers to Exercises in the Text

1.1 Compensation under which the insurer receives a percentage of each approved claim could lead to
inflated claims by insurance adjusters. It may be profitable for an insurer to slow down the claims
process if an hourly rate is used. A flat fee might reduce the effort an insurer puts into adjudicating
claims. The combination of a flat fee per case plus a modest hourly rate to handle claims might be a
better system (but too high an hourly rate could also lead to opportunistic behavior). Another
effective option might be to have the insurance company set a competitive premium that the
government then subsidizes.

1.2 By making this commitment, the company may be trying to assure customers who cannot judge how
quickly the product will deteriorate that the product is durable enough to maintain at least a certain
value in the future. The firm is trying to eliminate asymmetric information to increase the demand for
its product.

1.3 There may be an incentive for investment managers to shirk with such a contract. Because the
manager is paid even if no trades are executed, a manager may have more incentive to spend his or
her time searching for more assets to manage than watching for ways to increase the portfolios of the
individuals that he or she already manages.

1.4 This is an example of moral hazard, where doctors who perform their own lab work have an incentive
to test more than the optimal number of samples because they profit from doing so.

If adverse selection were present, where doctors who perform their own lab work have clienteles
unusually likely to have prostate cancer, then we might expect more samples being tested and more
cases of prostate cancer being discovered. Instead, doctors who perform their own lab work discover
fewer cases of prostate cancer than doctors who use independent labs.

1.5 Moral hazard is opportunism characterized by an informed person taking advantage of a less-
informed person through an unobserved action. The moral hazard here is that some companies may
take advantage of less-informed consumers by selling them products that may put their health at risk.
Third-party certification and labeling is one way of helping to level the playing field by providing
information to consumers, thus lessening the moral hazard problem. Some consumers would continue
to buy the now cheaper, uncertified goods, but the higher prices charged for the certified products
could also encourage companies selling uncertified products to improve the safety of their products.

2.1 This agreement led to very long conversations. Whichever of them was enjoying the call more
apparently figured that he or she would get the full marginal benefit of one more minute of talking
while having to pay only half the marginal cost. What I learned from this experience was not to open
our phone bill so as to avoid being shocked by the amount due (back in an era when long-distance
phone calls were expensive).

2.2 A partner who works an extra hour bears the full opportunity cost of this extra hour but gets only half
the marginal benefit from the extra business profit. The opportunity cost of extra time spent at the
store is the partner’s best alternative use of time. A partner could earn money working for someone
else or use the time to have fun. Because a partner bears the full marginal cost but gets only half the
marginal benefit (the extra business profit) from an extra hour of work, each partner works only up to
the point at which the marginal cost equals half the marginal benefit. Thus each has an incentive to
put in less effort than the level that maximizes their joint profit, where the marginal cost equals the
marginal benefit.

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365  Perloff • Microeconomics: Theory and Applications with Calculus, Fourth Edition, Global Edition

2.3 Arthur does not sell the quantity of ducks that maximizes joint profits. Instead, he sells a quantity that
is less than that amount. This is because Arthur bears 100 percent of the marginal cost of each
carving he sells, but he gets only a portion of the marginal revenue. If Arthur were to get to keep a
larger share of the revenue (and a larger share of the marginal revenue), then he would have incentive
to sell more ducks, and joint profits would increase.

2.4 If Paula pays Arthur a fixed-fee salary of $168, Arthur has no incentive to buy any carvings for
resale, given that the $12 per carving cost comes out of his pocket. Thus Arthur sells no carvings if he
receives a fixed salary and can sell as many or as few carvings as he wants. The contract is not
incentive compatible. For Arthur to behave efficiently, this fixed-fee contract must be modified. For
example, the contract could specify that Arthur gets a salary of $168 and that he must obtain and sell
12 carvings. Paula must monitor his behavior. (Paula’s residual profit is the joint profit minus $168,
so she gets the marginal profit from each additional sale and wants to sell the joint-profit-maximizing
number of carvings.) Arthur makes $24  $168  $144, so he is willing to participate. Joint profit is
maximized at $72, and Paula gets the maximum possible residual profit of $48.

2.5 Presumably, the promoter collects a percentage of the revenue of each restaurant. If customers can
pay cash, the restaurants may lie to the promoter about the amount of food they sold. The scrip makes
such opportunistic behavior difficult.

2.6 Yes, it is efficient because the agent has the incentive to produce the profit-maximizing quantity. The
fixed fee serves as a profit tax, which does not change the marginal condition.

2.7 If the output market is competitive, the firm maximization problem is as follows:
p  pq  apq  C(q).
Differentiating and setting marginal revenue equal to marginal cost implies that the firm produces where
p  ap  MC,
which results in a lower output than joint profit maximization (achieved by setting p  MC).

2.8 John’s objective is to maximize his expected profit:

The F.O.C. is:

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 Chapter 19 Contracts and Moral Hazards  366

Assume that , then , and the solution to the F.O.C. is:

The S.O.C. is:

Therefore the S.O.C. is satisfied at and hence John’s optimal fraudulent profit is:

2.9 a. The joint profit function is Differentiating with respect to

Q and setting the derivative equal to zero, and Thus, the maximum joint
profit is
b. Indira’s profit function Differentiating with respect to Q and setting
the derivative equal to zero, and (unchanged from part a). Indira’s profit is
Since Kamala receives 35,825, joint profit is still maximized.
c. Kamala’s profit function is Differentiating with respect to Q and setting the
derivative equal to zero, and Kamala’s profit is Indira receives
(the same as in part b). Joint profit is 49,025, which is less than the
maximum.
d. Indira’s profit function Differentiating with respect to Q and setting the
derivative equal to zero, and Indira’s profit is (unchanged
from parts b and c). Kamala receives Joint profit is 49,357,
which is less than the maximum, but higher than in part c.

2.10 E[ (keeping macro)]  0.5(100  52  42  52)  0.5(32  52  42  52)  $24.

E[ (keeping micro)]  0.5(100  32  42  52)  0.5(52  32  42  52)  $14.

Therefore it will keep macro and return micro.

The wholesale price is a sunk cost and is therefore ignored. The text that is returned is the one that
has a higher return compensation.

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3.1 In this case, the problem arises because a given doctor receives the same amount of revenue no matter
how many or few times the physician sees a patient. Although the income variation is reduced by this
scheme, it creates a moral hazard problem. Each individual doctor collects all the gains from shirking
(receives the leisure) but only pays a portion of the cost, as it is shared with other doctors in the group.

3.2 The payoff to Padma will be a function of the actual value of the recoverable sunken treasure and of
how hard Aaron works to retrieve it. If Aaron is paid a flat fee and the amount of recoverable treasure
is unknown to Padma, this payment method is inefficient because Aaron has no incentive to work hard
enough to recover the treasure, and Padma cannot be certain how hard Aaron has actually worked. If
Padma is certain of the recoverable value, a flat fee might be an efficient deal for her if she can require
Aaron to work until the full value of the treasure is recovered. Having Aaron pay a flat fee to Padma
for the right to recover the treasure would be an efficient solution if the treasure’s value recoverability
is unknown.

3.3 Such a law would interfere with the ability to write an optimal contract. It would force the franchisor
to continue to support a franchisee even when that franchisee is underperforming, even to the point of
making losses. Reputation, paid advertising, and other expenses paid by the franchisor represent a
subsidy to the franchisee. If a franchisee is losing money and would otherwise have to close, but
instead continues to consume benefits, efficiency is reduced and risk is shifted to the franchisor.

3.4 Moral hazard is opportunism characterized by an informed person’s taking advantage of a less-
informed person through an unobserved action. Moral hazard results in this instance because Louisa
has less incentive to practice bike safety with insurance because the insurance company bears the cost
if her bike is stolen. In particular, moral hazard problems are more likely to result from full insurance
because Louisa bears less (actually, none) of the consequences of her actions than with partial
insurance (where she would bear a percentage of the cost of the bike if it is stolen).
With full insurance, Louisa will not undertake any bike safety due to problems associated with moral
hazard, so there will be a 20 percent chance the $800 bike will be stolen. To recover this cost, the
insurance company will have to charge a premium of $160.

Relative to having full insurance, if Louisa purchases partial insurance, then she will take more safety
precautions because she bears more of the cost of the consequences of her actions ,and she will bear
more risk because she is not completely insured against theft.

3.5 a. If the author receives a lump-sum payment, the solution is equivalent to a profit tax. The firm
produces the profit-maximizing quantity and price as it would if no payment were due, and then
pays the author the lump sum.

b. If the author is paid a share of revenue, the firm’s marginal cost curve increases to reflect the
royalty paid to the author. Assume that demand is linear, p  a – bq. Total revenue is R  aq  bq2.
Marginal revenue is MR  a – 2bq. Total cost is aR  C(Q)  a(aq – bq2)  C(Q), and marginal
cost is MC  a(a – 2bq)  dC/dq.

c. If the author receives a lump sum and a percentage, the shift in the marginal cost curve is like
that described in part (b) above, causing a distortion from the joint profit-maximizing output,
and the remaining lump sum is deducted from profits.

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When authors are paid a share of the revenue, then the textbook company bears the full marginal
cost but receives only a portion of the marginal revenue from selling textbooks. As a result,
revenue-sharing contracts are not incentive compatible because the textbook company sells fewer
than the number of textbooks that would maximize joint profit. Instead, joint profit would be
maximized if authors were to receive lump sum payments.

3.6 In the figure, the quota is shown as a vertical line at q*, and initial demand is D0. Initially, the quota is
exactly satisfied, the patient visits the doctor q* times, and the insurance company pays the fee p0. If
the patient’s demand increases, the insurance company will not pay for more visits. If the quota were
set such that no additional visits were possible, the price would increase to p1. If fees are fixed at p0,
the insured must pay the difference between p1 and p0. Also (assuming perfectly elastic supply in this
range), the patient can consume beyond the quota limit by paying out of pocket for the additional q1 –
q* visits. In this case, the moral hazard problem of overconsumption is reduced, and some of the risk
is transferred to the insured.

4.1 The bond is posted because law firms exist and thrive primarily based on their reputations. If a partner
were to become involved in illegal activities and he or she were caught, it would seriously damage
the reputation, and thus the value, of the firm. Bonds are also used to prevent shirking. If a partner
knows that he or she risks losing a large bond by shirking, it reduces the probability that shirking
will occur.

4.2 The minimum bond that deters stealing is $2,500.

4.3 A risk-neutral worker would just be deterred from stealing when the gain, G, equals the expected
fine, F. Thus, the minimum fine necessary to deter stealing would be F = G/ = 200/0.02 = 10,000
euros. Since one extra unit of monitoring, M, raises the probability of the firm catching a worker who
steals, by 0.5%, the probability of being caught being  = 2%, the firm would require M = 0.02/0.005
= 4 units of monitoring. The firm would hire this many units if the cost of monitoring, wM  G (the
gain from preventing a theft of 200 euros). Thus, the maximum cost of hiring 4 units profitably would
be w = G/M = 50 euros/unit.

4.4 a. A risk-neutral worker would be just deterred from stealing when the gain, G, equals the expected
fine, F. Thus, the optimal fine to deter stealing would be F = G/ = 800/0.2 = 4,000 euros.

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369  Perloff • Microeconomics: Theory and Applications with Calculus, Fourth Edition, Global Edition

b. The worker chooses not to steal if the efficiency wage, w, exceeds the expected return from
stealing: Thus, euros.

c. In this case, the worker chooses not to steal if the efficiency wage, w, exceeds the expected return
from stealing including the expected penalty if caught: Thus,
euros.

d. There is a trade-off between the size of the efficiency wage and the penalty. The efficiency wage
falls as the penalty increases.

4.5 The price difference between used rental cars and used cars owned by individuals is due to moral
hazard: those who rent cars likely do not take as good of care of them as those who own cars because
renters do not reap the benefits of caring for the cars they rent. So, prospective buyers are not willing
to pay as much for used cars that were rented. Car rental companies could inspect the cars they rent
more carefully, but they instead often only conduct a brief, cursory inspection because inspections are
expensive.

4.6 Large builders with significant assets are more likely to build high-quality buildings because they
have assets to lose if sued. Likewise, requiring builders to post bonds or some similar legal remedy
would be likely to reduce moral hazard.

5.1 For a firm to sort between hard-working and lazy employees using contingent and fixed-fee contracts,
the lazy employees and the hard-working employees must prefer different contracts. Specifically, the
lazy employees must prefer the fixed-fee contract (which does not depend on work effort), and the
hard-working employees must prefer the contingent contract (which rewards effort with higher pay).

6.1 In bad economic times, the demand for most firms’ products falls. Many firms respond by laying off
workers or by lowering wages. Workers don’t know whether firms are actually facing a downturn, so
they often refuse wage cuts. In turn, firms lay off workers. However, layoffs are not optimal either
because workers lose income and the firm loses production. In these instances, suboptimal outcomes
result due to asymmetric information: firms have more information than workers do about economic
conditions. Outcomes could be improved if worker wages could be tied to measures of economic
conditions such as the firm’s output sold, revenue, or profits.

7.2 The advantage of this compensation package is that it ties Ms. Whitman’s incentives to the value of
company stock, which is of primary concern to shareholders. As such, it should reduce moral hazard
and increase efficiency, although Ms. Whitman incurs more risk than she would with a fixed salary.
One downside is that Ms. Whitman may make decisions to increase profits immediately (in the short
run) at the expense of making longer-term investments that would increase the company’s value over
time (in the long run), particularly if Ms. Whitman isn’t sure she would still be the CEO when long-
term investments begin to pay off.

7.3 If Adrienne launches the new product, then there is a 30 percent she will receive 10 percent of the
amount of $20 over $8 million. The other outcomes when launching the new product will not
generate profit over $8 million. So, if Adrienne launches the new product, then she would expect to
receive $1.2 million (from 10 percent of $12 million).

If Adrienne makes minor changes to an existing product, then she will receive 10% of the amount of
$10 over $8 million, which would be $0.2 million. Since $1.2 million is greater than $0.2 million,
Adrienne will launch the new product.

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 Chapter 19 Contracts and Moral Hazards  370

The expected value (EV) of launching a new product is

EV = (30% × $20) + (40% × $5) + (30%* – $10)
EV = $5 million.

The value of making minor changes to the existing product is $10 million with certainty. So, the
shareholders will not be pleased that Adrienne launches a new product.

Potential problems with Adrienne’s contract result because Adrienne does not have the same
incentives as shareholders. Adrienne and shareholders will be better off if a contract is structured
such that they have the same incentives. Since shareholders are concerned about profit, Adrienne’s
contract should pay her based on profit.

7.4 The profit on the Nikons is expected to be $400,000. The expected value of the grey market cameras
is (0.5)(1,000,000) + (0.5)(–300,000) = $350,000. Thus Curtis expects to earn $40,000 selling the
Nikons, but because he shares in profits but not losses, his expected salary from the grey market
cameras is (0.5)(100,000) + (0.5)(0) = $50,000. Thus, he will choose the grey market cameras. In
order to deter Curtis from choosing the more risky scheme, the owner could pay him a salary plus
bonus over a longer period, as suggested in the Challenge, or otherwise tie Curtis’s salary to losses as
well as gains, so that his incentives are better aligned with those of the owner.

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