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Question: In our story Principal owns many ice cream parlors across North America. Principal contracts with Agent to manage his Miami shop. Her duties include supervising workers, purchasing supplies, and performing other necessary actions. The shop's daily earnings depend on two things: on the local demand conditions and on how hard Agent works. Demand for ice cream varies with the weather, and is high half the time, and low otherwise.
(a) Consider the situation of Symmetric Information - Moral hazard is not a problem if Principal lives in Miami and can directly supervise Agent. Say they could agree to a contract that specifies Agent receives a wage of $350 per day if she exerts high effort regardless of the weather conditions, but loses her job if she doesn't. What is Agent's net payoff? Principal's expected payoff? Is the contract efficient in risk bearing? (Hint: Note that Agent's wage may not always be the same as her net payoff - Don't forget to take into account that putting high effort is tiring and prevents Agent from spending time at the beach with friends, and Agent's cost of exerting high effort is $100.)
(b) Suppose that Principal can no longer observe Agent's effort directly. The contract is then revised such that Principal pays Agent a fixed wage of $450 regardless of how much profit the shop earns. What is Agent's net payoff? Principal's expected payoff? Is the contract efficient in risk bearing? Is the contract efficient in production? (Hint: The contract in part (a) is efficient in production.)
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