MBA 775
Problem Set 3
Group 16
1. Moral Hazard and Incentive Contracts
Suppose you start up a company and develop a new computer game. If you succeed, the profits
are $200,000. If you fail, of course you earn nothing. You need to hire a programmer to code up
the game. If the programmer works with high effort, the probability of success is 80%. If he
works with low effort instead, the probability of success is 60%. To motivate your programmer,
you give him the following incentive package: a salary 𝑠 and a bonus 𝑏. The bonus is only
awarded conditional on the game being successful. High effort costs the programmer $20,000,
and he can earn $50,000 at another job that doesn’t require high effort.
a. Write down the programmer’s incentive compatibility constraint to exert high effort.
b >= 100000
b. Write down the programmer’s participation constraint
s + 0.8 b >= 70000
c. What is the optimal contract for the programmer? Optimal refers to the lowest cost to
you.
s = -10000, b = 100000
d. Assume that the contract must satisfy limited liability so that 𝑠 ≥ 0 and 𝑏 ≥ 0. What is
the optimal contract?
s = 0, b = 100000
2. Asymmetric Information in Bilateral Trade
Suppose you are in the process of buying another company. The company is either good or bad. If
it is bad, it worth 0 to everyone. If it is good, it is worth $1 to the seller and $2 to you. Initially,
neither you nor the seller knows exactly whether the company is good or bad. Instead, both think
the two possibilities are equally likely. The seller gets the results of an internal audit that
examines the state of the company in details. The audit result is either positive or negative, but
only the seller is able to see this result.
a. In this game, which player is informed? Which player is uninformed? Which piece of
information is asymmetric between the two players?
Informed player: seller. Uninformed player: buyer. Asymmetric information: the audit report
about whether the firm is good or bad.
b. Suppose the audit report is only accurate 70% of the time. In other words, if the company
is in a good state, the report is positive with probability 70%. If the company is in a bad
state, the report is negative with probability 70%. What is the possibility that the
company is good conditional on a positive report? What is the possibility that the
company is good conditional on a negative report?
P(good | positive report) = 0.7, P(good | negative report) = 0.3
c. How much does the seller value the firm following a positive report? How much do you
(the buyer) value the firm following a positive report? How much does the seller value
the firm following a negative report? How much do you (the buyer) value the firm
following a negative report?
After a positive report: seller values the firm at 0.7, buyer values it at 1.4. After a negative
report: seller values the firm at 0.3, buyer values it at 0.6.
d. Suppose you, the buyer, make a take-it-or-leave-it offer to the seller. How much should
you offer? Note: in a take-it-or-leave-it offer, the buyer will of course offer the lowest
possible price that induces the seller to accept it.
Offer price = 0.7
3. Cheap talk (not required)
Consider a firm decides which job to assign to its workers. The job can require either high or low
skill. Workers have either high or low ability, with equal probability.
a. Suppose both the worker and the firm get a payoff of 2 when the worker is matched to the
corresponding job and 0 when there is mismatch. If the worker can send a costless
message, 𝑚 ∈ {𝐻, 𝐿}, what will be the equilibrium outcome? What message will the
worker send? What are the payoffs to the worker and to the firm?
High-ability worker sends message H and is assigned the high-skill job. Low-ability worker
sends message L and is assigned the low-skill job. Payoffs are 2 to the worker and 2 to the firm.
b. Consider a different payoff structure. Both types of workers (high and low ability)
receive a payoff of 3 if they are assigned to high-skill jobs. A high ability worker receives
0 payoff if assigned to a low-skill job, whereas a low ability worker still receives 2 if
assigned to a low-skill job. The firm’s side, it receives a payoff of 2 if a low job is
fulfilled, irrespective of the worker’s type. If a firm fulfills a high job, it only receives a
payoff 2 if the worker has high ability. Otherwise, it receives nothing. (See Table 1 and 2
if there is still any confusion). The workers are allowed to lie without punishment. What
will be the equilibrium outcome? What message will the worker send? What game is
this?
Both types of worker send message H, the firm ignores the message and always
assigns the low-skill job. This is a cheap-talk game with a babbling equilibrium.
Table 1 Worker’s Payoff Table 2 Firm’s Payoff
High Job Low job High Job Low job
High ability 3 0 High ability 2 2
Low ability 3 2 Low ability 0 2