Answer to Question #208726 in Macroeconomics for Juhi

Question

A principal outsources a work to an agent to deliver y units of output within one month.

(a) Suppose effort is observable. How can the contract be designed so that the agent can be outsourced the first-best level of output?

(b) Now suppose that effort is not observable. Suppose that the agent is risk-averse. Characterize

the contract in this case, clearly

Answer 1

a)When the effort is observable. The contract should specify the principal's effort level and make sure it is protected from related risks. The contract should be designed to specify efficient effort choice as well as completely insure the agent concerning the risks.

b). In this case, only the outcome, R_L or R_H can be observed. Hence, there is a chance for the principal to receive R_L even when an agent puts more effort _eH, and another possibility for the principal to gain R_H even when the principal is exerting low effort.Therefore, the results may not effectively display the effort of the agent since respective principal may be observing results only.