Problem Set 10.

Hidden Action Problem

1. Pay for Performance

Part 1
Suppose for now that there is no asymmetric information, and the salesperson's effort is perfectly
observed by the store owner. If low effort is exerted, the store generates a revenue of 8. If the
salesperson exerts high effort, the revenue increases to 14.

The store owner offers a complete contingent contract to the salesperson, specifying a wage for each
effort level: w(L) for low effort and w(H) for high effort. The extensive form and associated pay-offs
for each player are depicted below.

a) Explain why the pay-offs for the store owner and the salesperson have the values they do for
each of the three possible outcomes of the game.
b) For each of the three possible outcomes of the game, find and explain the value of the
surplus being realized. What is the socially efficient outcome?
c) Find the expression for the incentive compatibility constraint for high effort (ICC).
Concisely explain your logic and interpret the resulting expression.
d) Assuming the above ICC is in place, find the expression for the participation constraint.
Concisely explain your logic and interpret the resulting expression.
e) Describe the strategies that constitute the subgame perfect equilibrium for this game and
concisely explain why these strategies form the subgame perfect equilibrium.
f) Suppose the salesperson's reservation wage increases to 3 instead of 1. Concisely explain
how this change affects the equilibrium pay-offs for the players.

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Part 2
Now suppose there is asymmetric information: the store owner only observes the revenue, not the effort
exerted by the salesperson. However, it is common knowledge that high effort leads to high revenue
with an 80% probability, whereas low effort results in a 20% probability of high revenue. The updated
extensive form game is presented below.

g) "A (wage) contract specifies an action for each information set." Explain how this statement
applies to the current setup.
h) Find the updated expression for the incentive compatibility constraint for high effort (ICC).
Concisely explain your logic and interpret the resulting expression, including any differences
with the ICC from Part 1.
i) Assuming the updated ICC is in place, find the expression for the participation constraint.
Concisely explain your logic and interpret the resulting expression.
j) The pay-off maximizing contract for the principal is w(14)=5 and w(8)=0. Why is the
optimal w(14) higher than the optimal w(H) from Part 1?

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 2. Principal-agent problem with risk-averse preferences by the agent

Assume a principal has to design an optimal contract [m,n]. The payments m and n are made to the
agent when the observable output is respectively Low and High. The choice of contract by the
principal intends to induce the agent to provide a high level of effort. The costs of effort for the agent
are 0 and 1 when the level of effort is respectively Low or High. The agent is allowed to reject the
contract of the principal when it is offered. This results in a payoff of 0 for the principal and 1 for the
agent.

The effort of the agent together with the external circumstances determine the output result R. The
outcome is either R = 5 or R = 40. The effort of the agent influences the probability of favourable
circumstances. If the agent does not provide effort, then the probability of a low outcome is 3/4. If
the agent does work hard, then the probability of a low level of output is 1/4. The payment for the
principal is equal to R minus the payment to the agent according to the contract. The payments are
valued by the agent as √m and √n. The costs of effort are equal to the level of effort and have to be
subtracted from this amount.

A Present the extensive form, while assuming that the principal is not informed about the effort of the
agent.

B Formulate the incentive compatibility constraint regarding the contract [m,n] such that the contract
induces the choice High instead of Low by the agent.

C Formulate the participation constraint.

D Determine the optimal contract.

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 3. Team production and free riding
Team production means that the individual contributions of team members cannot be distinguished,
i.e. there is joint production. An example is moving a piano. The total result can be easily determined,
but the effort of each individual team member cannot. Payments to individual team members have
therefore to be based on the joint result.
Assume there are 2 team members. Define the effort level of agent i as e i with i=1,2. The level of
effort is either .5 or 1. The level of output is equal to the sum of the effort of the 2 agents. Agents
choose their level of effort individually and simultaneously. The value of output is divided equally
between the team members, i.e. each team member receives a share 1/2 of the value of output. An
agent bears the costs of providing effort completely, where the costs of effort is 1/8 when e=.5 is
chosen and 1/2 when e=1 is chosen.
A Present the strategic form.
B Specify the Nash equilibrium.
C Is the Nash equilibrium efficient? Specify in your answer the efficient choice of effort of each agent.

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Suppose that a principal starts to reorganize the team by implementing a wage contract, i.e. the payoff
facing the team members are changed. The principal offers the 2 agents a wage consisting of a fixed
salary S and a piece / bonus rate B times the average output per agent. Agents choose again their level
of effort, either e=.5 or e=1, individually and simultaneously.
D Present the strategic form of the game regarding the choice of effort of the agents.
E Determine the incentive compatibility constraint for the choice of the bonus B.
F Assume that an agent is able to earn .25 elsewhere. Determine the participation constraint.
G Determine the optimal contract for the principal to induce the efficient, i.e. total surplus
maximizing, output.
H Explain why the fixed salary is negative.

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 4. Project supervision
Suppose that you are the owner of a company that is undertaking a new project. You have to hire a
manager to supervise it. The success of the project is uncertain, but good supervision can increase the
probability of success. Managers are only human, though: they try to get away with as little effort as
they can (because exerting effort is costly in terms of the extra time diverted from family, friends, or
other pursuits). You yourself are risk neutral.
Suppose that if the project succeeds, it will earn the company a profit of €1000 over material and
wage costs. If it fails, the profit will be zero. With good supervision, the probability of success is one-
half, but if supervision is poor, the probability of success is only one-quarter. The manager you want
to hire is currently in a steady job elsewhere that gets him €100; to get the manager to accept a job
with your firm, you must pay him at least as much, but the extra effort costs the manager an
equivalent of €50.
The sequence of decisions in this principal-agent problem is as follows.

If your manager’s effort is observable, you can write a contract that compensates the manager for his
trouble efficiently to bring forth good supervision effort.
A Specify the payoffs in the extensive form.
B Which outcome is efficient? Explain your answer.
C Determine the Incentive Compatibility Constraint (ICC).
D Determine the Participation Constraint when the ICC for high effort is satisfied.
E Determine the profit maximizing compensation policy.
F Explain why it is fine that the previous parts have determined the profit maximizing contract {w(L),
w(H)} for the owner, while the specification of the contract could have been {w(LF), w(LS), w(HF),
w(HS)}.

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If the owner cannot observe effort, you have to try to give the manager incentives based on the success
of the project, e.g., a bonus if the project is successful. The owner designs a compensation policy to
maximize the expected profits of the company recognizing that the manager’s choice of effort depends
on the nature and amount of the compensation.
G Specify the contract, the payoffs and the information structure in the extensive form.
H Which outcome is efficient? Explain your
answer. I Determine the Incentive Compatibility
Constraint.
J Determine the Participation Constraint.
K Determine the profit maximizing compensation policy of the owner.
L Explain why the payment for success has to be so large.

A Which outcome is efficient? Explain your answer.

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D Determine the surplus maximizing compensation policy of the owner.
Part D shows that inducing extra effort would require the firm to offer a compensation scheme with a
negative base salary; that is, if the project fails, the manager pays the firm an amount stipulated in the
compensation policy.
E Show that if a negative base salary is not feasible, then the firm does better to settle for low pay and
no extra effort.

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