Reference no: EM132851796

Consider a principal and agent transaction. Assume the agent has a utility function of the form U(w,a)=w-a, where U(w,a) is the utility, 'w' is the wage and 'a' is the disutility related to effort. Further assume that the reservation utility is 140. Two levels of effort are possible, low effort, which expends 0, and high effort which expends 20. The principal is prepared to offer $180 to the agent is she works hard but is concerned with the possibility of moral hazard. Assume the agent is risk neutral.

From previous experience the principal has determined the following:

LOW EFFORT
HIGH EFFORT
Sales
Probability
Sales
Probability
450
0.3
450
0.7
250
0.7
250
0.3

(a) Design a contract that eliminates the need for monitoring and eliminates the moral hazard problem.

(b) Using your answers from (a), explain how this contract solves the moral hazard problem.