1.(30’)Answerthefollowingquestionsinwords.

i)Thefollowinglistdepictspartiesthatformacontractualrelationshipandprovidesreasonsforsuchcontracts.Identifytheprincipal(uninformedparty),theagent(s)(informedparty),veri…ablevariablesandinformationasymmetries.

(a)licensor,licensee,qualityofthetechnology.

(b)buyer,seller,qualityorwarranty.

(c)potentialbuyers,auctioneer,valueoftheitem.

ii)Underwhatcircumstancestheunobservabilityofanagent’se¤ortdoesnotimpedee¢ciency?Why?

iii)Whatarethebasictrade-o¤sinstandardmoralhazardmodels?iv)Useeconomicsofinformationtoexplain:

a)Whydoesa…ancialmarketprovideinsu¢entcredit?

b)Caninformationasymmetriesexplainthepricedi¤erentialbetweenbusi-nessandeconomyclassforregional ights?

2.(40’)MoralHazard

TheprincipalhasaprojectwhichneedsinitialinvestmentI.Theprincipalcannotexecutetheprojectbyherselfandneedstohireanagenttoimplementit.Thereturnoftheprojectis100ifitsucceeds,and0ifitfails.Iftheagentexertsane¤ortlevelof,theprojectsucceedswithprobability0:8andfailswithprobability0.2.Iftheagentexertsnoe¤ort,theprojectsucceedswithprobability0:5.Exertinge¤ortcoststheagent ;exertingnoe¤ortcostsnothing.Furthermoretheagent’sstatusquoutilitylevelisnormalizedto0.AssumeI>50sothattheprojectisnotvaluableiftheagentexertsnoe¤ort.

i)Risk-neutralagent.Assumetheagentisrisk-neutral:u(t; )=t ,wheretisthetransferfromtheprincipaltotheagent, =3isthecostofexertinge¤ort1)FirsBest.Assumethee¤ortisobservableandveri…ableandcanthusbeincludedintoacontractenforcedbythecourtoflaw.Underwhichconditionwilltheprincipalimplementtheproject?

2)Unobservablee¤ort+Nolimitedliability.Assumethee¤ortisnotob-servableandhencetheprincipalcanonlyo¤eracontractbasedontheproject’sreturn.Showthatthe…rstbestisachievediftheagentisnotprotectedbylimitedliability.

3)Unobservablee¤ort+LimitedLiability.Assumethee¤ortisnotobserv-ableandtheagentisprotectedbylimitedliability,i.e.,transfertotheagentcannotbenegative.

a)Writedownthetheoptimizationproblemoftheprincipalunderincentive,participationandlimitedliabilityconstraints.

b)Whichconstraintsarebinding?Why?

c)Determinetheoptimalcontract.Underwhichconditionwilltheprincipalimplementtheproject?Comparethisconditiontothe…rst-bestoutcome,whatdoyoulearn?

ii)RiskAverseagent.Assumetheagentisriskaversewithutilityfunction

2u(t; )=10t t ,wheret( 1<t 10)istransferfromtheprincipaltotheagent, =30isthecostofexertinge¤ort1