Question

Avedo is considering signing a contract with Pomas to write a novel, which would be due in one year's time, and the two parties are considering the terms of the contract. Everybody understands that the profits (after expenses but before paying Avedo) of the novel are uncertain, but depend on the effort that Avedo expends, as shown in the table below. High effort would require Avedo to hire a nanny for her toddler, which would cost her $20,000 per year. Avedo and Pomas are both risk-neutral. Pomas cannot observe Avedo's effort level.

Choose correct answer/answers

Avedos effort level Probability of $50,000 in profits Probability of $200,000 in profits 20% Low Effort 80% High Effort 60%

Answer 1

Solution:

The correct answer is: b.). The expected total profits are equal to $80,000 if Avedo puts in Low Effort.

 

The expected profit = (80$\% \times$ 50,000) + (20$\% \times$ 200,000) = 40,000 + 40,000 = 80,000