Questions to Discuss today

We start by completing qn5 part c of 2017 paper which remained and then procced
1. State and prove the arrow’s impossibility Theorem
2. The owner of a firm, P, wishes to hire a manager, M, for a project in which the profits are
affected, to some extent by the manager's effort. The manager has two costly effort
levels, eH (high-effort) and eL (low-effort). The manager's effort is not perfectly
deducible from the observable level of profit, , which lies between  and  . The
manager receives a wage, w from the owner. The manager is an expected utility
maximizer with a Bernoulli utility function u(w, e) = v(w)  g(e) over his wage w and
effort level e. Assume that uw (w, e) > 0 and uww (w, e)  0 at all (w, e) (subscripts
denote partial derivatives) and u(w, e H) < u(w, e L) at w. The manager has reservation
utility denoted by u . Use this information to address the following questions;

(a) Explain the meanings of the derivatives and inequalities uw (w, e) > 0, uww (w, e)  0
and u(w, e H) < u(w, e L) and how they are related to v (w) and g  (e).
(b) Give an intuitive explanation of the contracts that the owner might have to offer the
manager.
(c) Suppose that the firm's profits are stochastically related to e by the conditional density
function f( | e) > 0 where the distribution of  conditional on eH first-order
stochastically dominates the distribution conditional on eL (i.e. the level of expected
profits when the manager chooses e H is larger than that from e L:   f( | e H) d >  
f( | e L) d). Derive and discuss the optimal contract when effort is not observable for
both the risk neutral and risk averse manager.

Be blessed

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