Microeconomics: Theory and Applications with Calculus, 3e (Perloff)
Chapter 19 Contracts and Moral Hazards
19.1 Principal-Agent Problem
1) In which of the following contracts is the agent’s payment unaffected by his performance?
A) fixed-fee contract
B) hire contract
C) contingent contract
D) sharing contract
2) The outcome of the state of nature affects the payoff to the agent under a
A) fixed-fee contract.
B) hire contract.
C) contingent contract.
D) All of the above.
3) Amy received her wage based on her working hours in the grocery store. The work contract she signed
is an example of a
A) fixed-fee contract.
B) hire contract.
C) contingent contract.
D) sharing contract.
4) Alex is hired as a sales agent and receives 10% commission on the sales price. The contract he signed is
a
A) fixed-fee contract.
B) hire contract.
C) contingent contract.
D) sharing contract.
5) Moral hazard occurs when contracts are written in such a way that
A) the interests of agent and principal converge.
B) the interests of agent and principal diverge.
C) agents will wish to maximize the principal’s utility.
D) production and risk-bearing efficiency are achieved.
6) Efficiency in risk bearing implies that
A) risk is completely eliminated.
B) the least risk-averse party bears most of the risk.
C) the most risk-averse party bears most of the risk.
D) all of the risk is borne by just one of the parties, regardless of the degree of risk aversion.
7) Production efficiency implies that
A) joint profits are maximized.
B) joint profits are minimized.
C) joint profits are zero.
D) joint profits can be increased.
8) If the agent has more information than the principal and there is only one state of nature, then
A) efficiency in both production and risk-bearing can be achieved.
B) only efficiency in production can be achieved.
C) only efficiency in risk-bearing can be achieved.
D) neither efficiency in production nor efficiency in risk-bearing can be achieved.
9) To reduce moral hazard, a firm may
A) pay workers at a piece rate.
B) offer a year-end bonus if firm profits are up.
C) offer stock options.
D) All of the above.
10) Piece rates are practical when
A) individual output can be easily measured.
B) the quantity of the work is of much less importance than quality.
C) both employees and employers engage in opportunistic behavior.
D) All of the above.
11) Which of the following is NOT a difficulty with using a piece-rate contract?
A) measuring output
B) eliciting the desired behavior
C) gaining worker acceptance
D) workers taking too much time to achieve a certain task
12) The moral hazard associated with managers whose productivity is difficult to quantify can be
decreased with
A) piece-rate contracts.
B) year-end bonuses.
C) decreased wages.
D) adverse selection.
13) Production inefficiency is more likely to occur when the principal has more information about work
performance than the agent does.
14) The type of contract selected depends on the information available to the parties.
15) When the production of a worker is relatively easily observable, the firm can pay a piece–rate.
16) Describe the characteristics of an efficient contract between a principal and an agent.
17) Explain how more than one possible state of nature affects contract choices.
18) When does it make sense to offer a worker a piece-rate contract?
19.2 Production Efficiency
1) Suppose an agent must pay the full marginal cost for an item but splits the marginal revenue with the
principal. As a result,
A) joint profit is maximized.
B) joint profit is not maximized.
C) the agent will not enter into such a contract.
D) the agent wishes to sell as many items as he can.
2) In a store that sells souvenirs, suppose an agent receives a $1 commission for each unit sold, and the
principal receives the residual profit. As a result,
A) joint profit is maximized.
B) the agent will sell until the principal‘s marginal cost equals $1.
C) no agent would enter into such a contract.
D) the agent wishes to sell as many units as he can.
3) Suppose the principal offers to share a percentage of the profit with the agent. Such a contract
A) will yield the same income for the agent as a hire contract would.
B) is incentive compatible.
C) creates a production inefficiency.
D) would not be acceptable to any agent.
4) If the principal has full information, production efficiency without supervision can occur with
A) a fixed-fee rental contract.
B) a profit-sharing contract.
C) an incentive-compatible contract.
D) All of the above.
5) Suppose two owners of a store agree to split the profit equally regardless of the number of hours each
spends working at the store. As a result,
A) production efficiency is achieved.
B) each enjoys only half the marginal benefit of an additional hour working in the store.
C) one will work all of the time while the other works zero hours.
D) each will work as many hours as if he or she were the sole owner.
6) Sue offers to pay Al $50 for each painting of his that she sells in her gallery. Each painting sells for $75.
The cost to Al of producing each painting is $55. Which of the following statements is true about this
contract?
A) This contract is efficient.
B) This contract maximizes joint profit.
C) Al will not participate in this contract.
D) This is a fixed-fee contract.
7) In the presence of asymmetric information, the only contract that results in production efficiency and
no moral hazard is the one in which
A) the agent receives a fixed fee.
B) the principal receives a fixed rent.
C) profit is shared.
D) revenue is shared.
8) In the presence of asymmetric information, a contingent contract
A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.
9) In the presence of asymmetric information, a hire contract
A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.
10) In the presence of asymmetric information, a piece-rate contract
A) achieves production efficiency.
B) can lead to agents producing more output than would occur under a fixed-rent-paid-to-the-principal
contract.
C) is impossible to write.
D) will result in the principal earning all of the profit.
11) The market demand for MP3 players is p = 50 – 0.5Q, and the marginal cost for Nick to obtain and sell
a MP3 player is $10. If he signed a fixed–fee rental contract with the store owner and pays $400 as the rent,
A) Nick will sell 20 MP3 players.
B) Nick will sell 30 MP3 players.
C) Nick will sell 40 MP3 players.
D) Nick will sell 50 MP3 players.
12) The market demand for MP3 player is p = 50 – 0.5Q, and the marginal cost for Nick to obtain and sell a
MP3 player is $10. If he signed a fixed–fee rental contract with the store owner and pays $1000 as the rent,
A) Nick will sell 20 MP3 players.
B) Nick will sell 40 MP3 players.
C) Nick will sell 50 MP3 players.
D) Nick will not sign the contract.
13) The market demand for MP3 player is p = 50 – 0.5Q, and the marginal cost for Nick to obtain and sell a
MP3 player is $10. If he receives $12 for each MP3 player he sells from the store owner and the store
owner controls the quantity of MP3’s available for sale, then
A) 40 MP3 players will be sold.
B) joint profit is $798.
C) joint profit will be maximized.
D) Nick will sell as many as he can.
14) The market demand for MP3 player is p = 50 – 0.5Q, and the marginal cost for Nick to obtain and sell a
MP3 player is $12. If he receives 60% of the MP3 sales revenue, then
A) Nick will sell 38 MP3 players.
B) Nick will sell 50 MP3 players.
C) Nick will receive $270 as profit.
D) Total profit is $342.
15) The market demand for MP3 player is p = 50 – 0.5Q, and the marginal cost for a MP3 player is $10. If
Nick receives 60% of the total profit, then
A) Nick will produce 50 MP3 players.
B) Nick receives $500 as profit.
C) total profit is $800.
D) the efficiency in production is not achieved.
For the following, please answer “True” or “False” and explain why.
16) In the presence of asymmetric information, production efficiency is assured when the principal and
agent share the profit.
17) With full information, any contract will lead to production efficiency.
18) Sam is suing someone in court for $10,000. The probability that Sam will lose the case is 1/h where h is
the number of hours that Sam’s attorney works on the case. The lawyer charges $500 per hour if he is to
be paid hourly, or he requests 20% of the settlement if he is to be paid on a contingency basis. Assuming
both Sam and the attorney are risk-neutral wealth maximizers, is either contract efficient?
19) Rents for stores at shopping malls are usually tied to the profits of the store. Comment on how this
arrangement affects the mall owner’s income versus a fixed rent.
20) If information is asymmetric, explain why the hire contract is not efficient in production and a moral
hazard exists, but the fixed fee to the principal contract is efficient and does not pose a moral hazard
problem.
21) Jacko’s rock band is putting out a new CD with its music label. The contract between the band and the
label specifies that the band receive 25% of the gross revenues plus another $10,000 up front. The record
label projects the demand for the album
p = 50 – 0.003Q
where p is the price per CD (in $) and Q is the number of CDs demanded. The cost (not including the
band’s salary) of producing the CD is constant at $5 per disc.
a. Compute the joint-profit-maximizing price and quantity.
b. Compute the profit maximizing price that the label will wish to set.
c. What price will Jacko want his band’s CD sold for (assume he only cares about money earned from
the CDs).
19.3 Trade-Off Between Efficiency in Production and Risk Bearing
1) Suppose a plaintiff hires a lawyer to represent her in a court case. The lawyer will be paid a fixed fee.
Under this contract,
A) production efficiency is achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.
2) Suppose a plaintiff hires a lawyer to represent her in a court case. The lawyer will be paid by the hour.
Under this contract,
A) production efficiency is not achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.
3) In the presence of asymmetric information,
A) all contracts are efficient.
B) efficiency in risk bearing cannot be achieved.
C) a trade-off exists between risk-bearing efficiency and production efficiency.
D) no contracting will take place.
4) Suppose a plaintiff hires a lawyer to represent her in a court case. The lawyer will receive a share of the
settlement if the plaintiff wins. Under this contract,
A) production efficiency cannot be achieved.
B) the client bears all of the risk.
C) the lawyer bears all of the risk.
D) the risk is shared.
5) Suppose a plaintiff hires a lawyer to represent her in a court case. She agrees to pay the lawyer a wage
per hour. She knows precisely what the lawyer should do and how long each activity should take, and
she can verify that the lawyer has correctly completed each activity. She can terminate the contract at any
time. With this contract,
A) the lawyer bears all the risk.
B) the risk is shared by the lawyer and the plaintiff.
C) production efficiency can be achieved.
D) production efficiency is impossible.
6) Suppose a plaintiff hires a lawyer to represent her in a court case. Under which of the following
contracts is production efficiency assured?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.
7) Suppose a plaintiff hires a lawyer to represent her in a court case. To which of the following contracts
would a highly risk-averse plaintiff agree?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.
8) Under which one of the following conditions would a lawyer accept a case on a contingent basis?
A) The lawyer is risk averse.
B) The client is risk loving.
C) The lawyer has several cases on a contingent basis with payoffs that are not perfectly positively
correlated.
D) The lawyer is more risk averse than the client is.
9) Under which one of the following contracts does an agent have the least incentive to behave
opportunistically?
A) The agent pays a fixed fee to the principal for the right to all future payoffs.
B) The agent works for the principal on an hourly basis.
C) The agent receives a share of the profit.
D) The agent works for the principal on a per unit basis.
10) Suppose a plaintiff hires a lawyer to represent her in a court case. Under which of the following
contracts is efficiency in risk bearing assured?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) It is impossible to determine without the degree of risk aversion for each.
11) One reason that lawyers might prefer a contingent contract when representing a plaintiff in a tort case
is that
A) lawyers are risk neutral.
B) diversification of many cases allows lawyers to reduce risk.
C) lawyers are typically confident about winning every case.
D) hourly rates for lawyers are usually very low.
12) A contingent contract can create production inefficiency; however, many principals accept this
because
A) inefficiency is inevitable.
B) monitoring is costless.
C) risk is reduced.
D) profit will increase as a result.
13) If an agent is risk neutral and a principal is risk averse, which of the following contracts would be
efficient in risk bearing?
A) A fixed fee is paid to the agent.
B) A fixed fee is paid to the principal.
C) An hourly rate is paid to the agent.
D) The agent enjoys a share of the profit.
For the following, please answer “True” or “False” and explain why.
14) In the presence of asymmetric information with costless monitoring and enforcement, a hire contract
results in production efficiency.
15) Sam hires an attorney to present a court case. If Sam wins the case, he will receive some money. This
payoff is a function of the attorney’s hours and which judge is assigned the case that day. Judge A is very
understanding toward people in Sam’s position, but judge B is very harsh toward people like Sam. Is it
possible for Sam to get the attorney to deliver the optimal amount of effort and make the attorney bear all
of the risk?
16) Sarah’s demand for routine medical visits is q = 10 – 0.2p when she is healthy and q = 20 – 0.2p when
she is sick. Medical visits cost $50 each if Sarah has no medical insurance. She is sick 20% of the time.
Sarah is considering two different insurance plans. One offers free medical visits; the other plan costs less
up front but requires that Sarah pay $5 per medical visit. Compare the two plans in terms of the trade-off
between risk and moral hazard.
19.4 Monitoring to Reduce Moral Hazard
1) If a firm has established monitoring devices that have a 50% chance of detecting shirking, and an
employee gains $5,000 from shirking, the employer can deter shirking by having employees post a bond
equal to
A) $2,500.
B) $5,000.
C) $10,000.
D) $50,000.
2) Monitoring is often used by firms in an attempt to decrease
A) shirking.
B) piece rates.
C) adverse selection.
D) signaling.
3) As the probability of detecting shirking increases, the size of the bond necessary to deter shirking
A) also increases.
B) stays the same.
C) decreases.
D) increases at an exponential rate.
4) Which of the following workers is most likely to be asked to post a bond?
A) construction contractor
B) fast food worker
C) sanitation worker
D) book author
5) Which of the following would not be used by firms to deter shirking?
A) requiring employees to post a bond
B) offering a bonus after five years of service
C) paying more than the market wage
D) paying less than the market wage
6) The benefit to employers of deferred-payments is that
A) adverse selection is eliminated.
B) employers cannot engage in any opportunistic behavior.
C) these payments raise the cost of being fired, so more monitoring is needed.
D) these payments raise the cost of being fired, so less monitoring is needed.
7) An efficiency-wage premium serves the same function as a bond because, just as with a bond, the
premium represents
A) the amount the employee loses if caught shirking.
B) the expected value of the amount the employee loses if he shirks.
C) the cost of monitoring the employee.
D) the gain to the employee if he shirks.
8) A profit-maximizing firm that uses an efficiency wage and monitors will increase the wage it pays its
workers until
A) the worker requires no monitoring.
B) the worker receives the market wage and requires full-time monitoring.
C) the cost of monitoring the worker equals the efficiency wage.
D) the change in the workers’ productivity from being monitored times the per time unit cost of
monitoring equals one.
9) If an additional dollar spent on monitoring would reduce shirking by 10 minutes, then the firm will
increase the worker’s wage by $1 if this caused
A) shirking to increase by less than 10 minutes.
B) shirking to decrease by more than 10 minutes.
C) shirking to decrease by less than 10 minutes.
D) monitoring to become unnecessary.
10) If all firms pay an efficiency wage, then
A) there is no cost to shirking because the shirking worker can receive his high wage at another firm after
being caught and fired.
B) the macroeconomy would enjoy a prolonged period of near-zero unemployment.
C) there is a cost to shirking because the efficiency wage is less than it would have been if only a few
firms paid it.
D) there is a cost to shirking because the shirking worker will spend a greater time unemployed after
being caught and fired.
For the following, please answer “True” or “False” and explain why.
11) When shirking at the workplace occurs, increased monitoring of workers is the only effective way to
reduce this behavior.
12) Explain why a firm may hire managers to operate outlets near the firm’s headquarters, but may sell
franchise rights for the outlets located greater distances from the headquarters. (With a franchise, the firm
sells a brand name and a method of doing business to someone who then owns and operates the outlet.)
13) Suppose the probability of an employee being caught shirking, q, is a function of the employer’s
monitoring, M, such that q = M/100. If workers must put up a $1,000 bond and the gain to each worker
from shirking is $100, what is the employer‘s optimal level of monitoring that is just sufficient to
discourage shirking?
14) Suppose an employer has monitoring devices established so that the probability of an employee being
caught while shirking is 0.2. If the gain to the employee from shirking is $1,000, how large a bond will
deter shirking?
15) Suppose employees pay a bond of $1,000 to an employer. The gain from shirking is $400. Monitoring
devices have been installed so that there is a 50% chance of being caught if you are shirking. The
company is considering the installation of additional monitoring devices to increase the chance of
catching a shirker to 100%. They feel this is needed to deter all shirking. What is your recommendation to
the company? Explain.
19.5 Contract Choice
1) One way to prevent workers from shirking is to
A) hire only workers who are predisposed toward shirking.
B) hire only workers who are predisposed toward not shirking.
C) reduce monitoring to zero.
D) pay workers a fixed fee.
2) Firms that seek to avoid hiring lazy workers that assert they are hardworking are trying to avoid
A) adverse selection.
B) moral hazard.
C) screening.
D) signaling.
3) A good salesperson can sell $1,000,000 worth of goods, while a poor one can sell only $100,000 worth of
goods. Job applicants know if they are good or bad, but the firm does not. A firm will offer job applicants
a choice between a fixed salary or a 20% commission. Assuming risk-neutral salespersons and no
opportunistic behavior, what level must the fixed salary be so that the firm can determine a prospective
good salesperson from a poor one?
A) between $0 and $20,000
B) between $20,000 and $200,000
C) greater than $200,000
D) zero
4) If good salespeople are extremely risk averse, then a choice between a fixed-fee contract and a
contingent contract
A) avoids a moral hazard.
B) will result in all job candidates choosing the contingent contract.
C) will result in an efficient contract.
D) may not be a good screening device.
For the following, please answer “True” or “False” and explain why.
5) A trade-off typically exists between incurring a moral hazard and making an adverse selection.
6) A good salesperson can sell $1,000,000 worth of goods, while a poor one can sell only $100,000 worth of
goods. Job applicants know if they are good or bad, but the firm does not. A firm will offer job applicants
a choice between a fixed salary or 20% commission. Assuming risk-neutral salespersons and no
opportunistic behavior, what level must the fixed salary be so that the firm can distinguish a prospective
good salesperson from a poor one, and thereby avoid hiring a poor one?
7) A good salesperson can sell $1,000,000 worth of goods, while a poor one can sell only $100,000 worth of
goods. Job applicants know if they are good or bad, but the firm does not. A firm will offer job applicants
a choice between a fixed salary of $25,000 or 20% commission. Assuming risk–neutral salespersons and
the possibility of opportunistic behavior, will this choice of contracts allow the firm to distinguish
between good salespersons and bad ones before the hiring decision is made?
19.6 Checks on Principals
1) Workers prefer layoffs to wage reductions during economic downturns because
A) layoffs benefit workers more than the firms.
B) workers try to provide firms with incentives to report true economic conditions.
C) firms will keep workers even during economic downturns to avoid more costs.
D) there is symmetric information.
2) Which of the following could prevent the opportunistic behavior of firms?
A) efficient contracts
B) good reputation
C) revealing relevant information about firms
D) All of the above