Problem Set: Contract Theory

Problem 1
A risk-neutral principal P hires an agent A, who chooses an effort a ≥ 0, which results in gross profit
x = a + ε for P, where ε is uniformly distributed on [0, 1]. A’s payoff equals

w1−ρ a2
u(w, a) = − ,
1−ρ 2

where w denotes a non-negative wage paid by P, and ρ > 0, 6= 1 is a parameter of (relative) risk-aversion.
A has an outside option of ū which is non-negative if ρ < 1 and negative if ρ > 1.

(a) If a is contractible, characterize the first-best wage and effort levels.

(b) If a is not contractible, but the profit x is contractible, and ρ ∈ (0, 1), find a condition on the
parameters of the problem (specifically, on ρ ) which ensure that the first-best profit can be achieved
by P. If ū = 0, when is this condition satisfied?

(c) If ρ > 1 what can you say about implementability of the first-best profit when a is not contractible?
How would you interpret these results?

Problem 2
Consider a contractual relationship between a landlord (principal) and a tenant (agent) who provide
inputs for the production of a single crop. Production requires one plot of land and one unit of labor. The
landlord is endowed with one unit of land and the tenant with one unit of labor. The landlord and the
tenant are both risk neutral. The tenant chooses two actions, to be referred to as effort and risk, which
affect the probability distribution of output ex-ante. These actions are denoted by e ∈ [e, ē] and r ∈ [r, r̄].
None of the actions can be observed by the landlord. The distribution of final output q ∈ [q, q̄] is given
by F(q | e, r) with the corresponding density f (q | e, r) which satisfies MLRP with respect to effort e,
i.e,  
d fe (q | e, r)
≥ 0.
dq f (| e, r)
The distribution of q is also affected by the choice of risk by the tenant. We assume that the tenant can
deliberately increase the riskiness of output in the sense that
Z q̂
Fr (q | e, r) ≥ 0 for all q̂ ∈ [q, q̄].
q

The tenant incurs a private cost for his actions ψ (e, r). Assume that this function is twice continuously
differentiable, monotonically increasing and convex in e and r. Also ψ (0, 0) and ψer (e, r) ≥ 0. A tenancy
contract is a tuple (R, s) where R is the fixed component and s is the share of output q that accrues to the
tenant. That is, for a given level of output q, the tenant earns sq − R and the landlord earns R + (1 − s)q.
Thus, when R < 0 and s = 0, the contract is a fixed wage contract, and when R > 0 and s = 1, the contract
is a fixed rent contract. When R > 0 and s ∈ (0, 1) the contract is a share-cropping contract. The tenant
is subject to limited liability with liability limits equal to 0. Moreover, the tenant’s reservation utility is
given by ū ≥ 0. With the above data in hand, answer the following questions:

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 1. Formulate the optimal contracting problem between the landlord and the tenant.

2. Solve for the optimal contract when both effect and risk are observable.

3. Solve for the optimal contract when both effort and risk are unobservable. Show that the optimal
contract is a share-cropping contract, and the optimal effort e∗ < eFB and risk r∗ ≥ rFB where eFB
and rFB are the first best levels of effort and risk, respectively.

4. Show that when only effort (risk) is observable, the optimal contract entails a fixed wage (rent).
Explain this result intuitively.

Problem 3
Consider a variant of the above problem where both the landlord and the tenant supply labor inputs, but
there is no choice of risk. Denoted by a ∈ [a, ā] the effort exerted by the landlord. Assume further that
the production function of final output is given by:

q = q(e, a) + ε ,

where ε is random variable with zero mean and variance σ 2 . Make the standard neo-classical assump-
tions on q(e, a), i.e., qe , qa > 0, qee , qaa < 0 and qea ≥ 0. Let ψ (e) and φ (a) denote the costs of efforts of
the tenant and the principal, respectively. Tenant’s reservation utility is given by ū ≥ 0. Denote by w(q)
the state-contingent transfer the tenant makes to the landlord.

1. Show that the outcome can be implemented by a linear contract of the form w(q) = R + (1 − s)q.

2. Solve for the optimal contracts when both efforts are unobservable.

3. Under what conditions the optimal contract entails s = 0 and s = 1? Interpret your results.

Problem 4
We consider two entrepreneurs each of whom can carry out a project with the following characteristics.
Investing 1 generates a stochastic output which can take two values, z > 0 or 0. The probability of success
(i.e., of getting z) depends in the entrepreneur’s effort, e, which can take also two values ē > 0 or 0. The
probability of success is p̄ for a high level of effort ē and p for no effort with p̄ > p > 0. The disutility of
effort is ψ for ē and zero for e = 0. Each entrepreneur has no wealth and must borrow to invest. He can
only repay his loan if he succeeds. Denoting by x the entrepreneur’s share of output, his expected utility
is (
p̄x − ψ if he exerts effort ē,
U (x, e) =
px if he exerts no effort.
Funds are supplied by a profit-maximizing bank which has a cost of funds r. We assume that

p̄z − ψ > r > pz

1. Determine the optimal contract offer to an entrepreneur when there is a single entrepreneur.

2. There are now two entrepreneurs who do not observe each other’s effort level. A group lending
contract calls for a payment x when the partner succeeds and y when he fails. Consider a group

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 lending contract which induces effort of both entrepreneur as a Nash equilibrium. Show that a
group lending contract does not perform better than the individual contracts considered in question
1.

3. We suppose now that entrepreneur observe each other’s effort level and coordinate their effort
levels. Consider the program of the bank which implements effort by both entrepreneurs with
group lending contracts:

max p̄(2z − 2x) + p̄(1 − p̄)(2z − 2y) − 2r

x≥0,y≥0

subject to 2 p̄x + 2 p̄(1 − p̄)y − 2ψ ≥ 2px + 2p(1 − p)y, (1)

2 p̄x + 2 p̄(1 − p̄)y − 2ψ ≥ 2p p̄x + p(1 − p̄)y + p̄(1 − p)y − ψ , (2)
2 p̄x + 2 p̄(1 − p̄)y − 2ψ ≥ 0. (3)

Explain each of the above constraints. Find the optimal contract. Show that it is better than
individual contracts for the bank. Explain why.

Problem 5
The Principal Car Sales Company has hired two sales agents i = 1, 2. Sales revenue achieved by agent i
equals xi = ai + ui , where ai is the effort of agent i, and u1 and u2 are normal, i.i.d., zero mean variables
with variance σ 2 /2. Both agents are risk-neutral and effort averse, but agent 2 has a lower disutility of
effort. So agent 1’s payoff is
a2
u(w1 , a1 ) = w1 − 1 ,
2
while agent 2’s is
β a2
u(w2 , a2 ) = w2 − 2 ,
2
where β ∈ (0, 1) and wi denotes the wage paid to i. Both agents have the same outside option utility of
ū. The car company’s payoff is x1 + x2 − w1 − w2 .

(a) If the car company can monitor effort and contract with the agents based on their observed efforts,
derive the (first-best) contracts and effort levels.

(b) Now suppose that the car company cannot monitor effort nor the actual revenues achieved by each
agent. It can only observe which agent achieved the highest sales. Find conditions under which
there is a symmetric rank order tournament (with a base salary of z and a ‘best sales agent’ prize
of W ) which implements the first-best efforts for a Nash equilibrium, in which each agent attains
at least his outside option in expectation.

(c) Show that the first-best level of expected profit cannot be attained by the car company with a
symmetric tournament.

(d) Can you suggest a modification of the tournament incentive scheme (i.e., based only on ordering
of the sales of the two agents) which will implement the first-best.

Problem 6
A monopolist wishes to sell a good produced at constant unit cost c to a large population of consumers

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with heterogenous preferences: a consumer of type θ has a payoff θ log q − t for consuming q > 0 units
of the good, and paying t dollars for it. If q = 0 then the consumer’s payoff is −t. The random variable
θ is distributed uniformly on [0, 1]. The monopolist cannot identify the type of any given consumer.

(a) If q(θ ) denotes the quantity sold to type θ , find a condition on this function q(·) that ensures that
it is incentive compatible, i.e., there exists some pricing rule t(q) for which q(θ ) is the optimal
purchase of type θ )).
(b) For any such incentive compatible q(·), what is the associated set of payments (i.e., t(θ )) that
customers (of type θ ) make to the monopolist?
(c) Obtain an expression for total prfit of the monopolist as a function only of the selling strategy q(·).
(d) Calculate the optimal selling strategy q∗ (θ ), and the pricing function t(q) which implements it (in
the sense of (a) above). (Note: Be careful about corner solutions.)

Problem 7
Consider a risk-neutral government that wants to establish a policy of subsidies to firms that carry out
efforts e to decontaminate. The cost to a firm of the decontaminating action is θ e2 , where θ is a parameter
whose value depends on the type of firm at hand, θ ∈ [1, 2]. The government’s policy consists in a certain
decontamination effort e and a transfer t that the firm will receive if decontamination has been carried
out. The firm will not accept the subsidy scheme if it does not at least cover the costs. The firm is
risk-neutral. The government bears in mind the social benefits of decontamination, valued at 2e. On
the other hand, the government prefers to pay the lowest subsidy possible to the firm. The only source
of government’s revenue is distortionary taxes. Let λ be the shadow cost of public funds, i.e., if the
government wants to collect $1 it costs her $(1 + λ ), and hence the social utility of transferring t dollars
to the firm is λ t (convince yourselves why?).

(a) Calculate the first-best level of decontamination e∗ (θ ) and transfer t ∗ (θ ).

(b) Now assume that the government does not know θ , and believes that it is uniformly distributed on
[1, 2]. Characterize the optimal mechanism M = {e(θ ), t(θ )}.
(c) The government is not always interested in offering a subsidy that all firm types will accept, but
rather sometimes it is preferable to leave out those firms with hight decontamination costs. Hence,
the government can design a mechanism M 0 = {e(θ ), t(θ ) | θ ∈ [1, θ 0 ]} where θ 0 ∈ (1, 2). Cal-
culate the optimal mechanism for a fixed θ 0 . Prove that it is optimal for the government to design
a mechanism intended for all firm types, i.e., θ 0 = 2.

Problem 8
We consider a firm which has a revenue R, but creates a level of pollution x from its activities. The
damage created by the level of pollution x is D(x) with D′ (x) > 0, D′′ (x) ≥ 0. The production cost of the
firm is C(x, θ ), with Cx < 0, Cxx > 0 and θ is a parameter known only to the firm, which can take two
values {θ̄ , θ } and ν = Pr(θ = θ̄ ) is common knowledge.

1. The level of pollution x∗ (θ ) corresponding to the complete information optimum is characterized

by
D′ (x) +Cx (x, θ ) = 0.

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 Show that, if the regulator is not obliged to satisfy a participation constraint of the firm, he can
implement x∗ (θ ) by asking a transfer equal to the cost of damage up to a constant.
2. Suppose now that the firm can refuse to participate (but in this case has a zero utility level) and
assume that the regulator has (up to a constant) the following objective function

W = −D(x) − (1 + λ )t + t −C(x, θ ) (4)

where t is the transfer from the regulator to the firm and 1 + λ is the opportunity cost of social
funds. When the regulator must satisfy the firm’s participation constraint

t −C(x, θ ) ≥ 0 for all θ ,

characterize the decision rule x̂(θ ), θ ∈ {θ̄ , θ }, which maximizes W under complete information.
Compare with Problem 1.
3. We assume in addition that Cθ < 0 and Cxθ < 0. Determine the menu of contracts (t, x) and (t¯, x̄)
which maximize the expectation of (1) under participation and incentive constraints of the firm.
4. Same problem when θ is distributed according to the distribution F(θ ) with density f (θ ) on the
interval [θ , θ̄ ] with  
d 1 − F(θ )
< 0, Cxxθ ≥ 0 and Cθ θ x ≤ 0.
dθ f (θ )

Problem 9
Consider a simple multitask agency model as in Holmstrom and Milgrom (1991). The economy consists
of two risk-neutral individuals: one landlord (L) and one tenant (T ). The landlord has two plots of land
which differ in quality. The production function of plot i = 1, 2 is given by Qi = θi ei , where θi ∈ [θ i , θ̄i ]
with 0 < θ i < θ̄i represents the productivity of plot i, and ei is the labor input or effort required in plot
i. Let the joint probability distribution of θ1 and θ2 be given by F(θ1 , θ2 ), and F1 (θ1 ) and F2 (θ2 ) be the
respective marginal distributions. We assume that the true realizations of productivity are independent
across plots, i.e, F(θ1 , θ2 ) = F1 (θ1 )F2 (θ2 ). The tenant has no initial wealth, and incurs cost of efforts
which is given by:
1
ψ (e1 , e2 ) = c1 e21 + c2 e22 + δ e1 e2 ,


2
√
with ψii = ci > 0 for i = 1, 2, and ψ12 = δ ∈ [0, c1 c2 ), which represents the degree of effort substitution.
Tenant’s efforts (e1 , e2 ) are not verifiable, and hence there are potential moral hazard problems in effort
choice. We normalize the tenant’s outside option to 0. A contract βi = (αi , Ri ) for i = 1, 2 specifies the
tenant’s share αi of output from plot i and the rental payment Ri to be made on plot i. If αi = 1 for i = 1, 2
and Ri > 0, then the contract is a pure rent contract on plot i. On the other hand, share contract emerges
when αi < 1 for at least one i. The contracts are subject to limited liability of the the tenant, i.e., when
the tenant fails to meet his rental obligations on plot i, the landlord confiscates the entire output from this
plot.

(a) Show that when δ = 0, in the second-best outcome, the optimal contract is a pure rent contract.
(b) Show that when δ > 0, in the second-best outcome, the optimal contract is a share contract, i.e.,
αi < 1 for some i = 1, 2. Find a necessary and sufficient condition for the optimality of share
contract.