2.4 Priscilla hires Arnie to manage her store. Arnie’s effort is given in the left column of the table. Each cell shows the net profit to Priscilla (ignoring Arnie’s cost of effort).

Arnie’s personal cost of effort is 0 at low effort, 10 at medium effort, and 30 at high effort. It is equally likely that demand will be low or high.
Arnie and Priscilla are risk neutral.
They consider two possible contracts: (1) fixed fee:
Arnie receives a fixed wage of 10; and (2) profit sharing: Arnie receives 50% of the firm’s net income but no wage.

a. What happens if they use the fixed fee contract?

b. What happens if they use the profit-sharing contract?

c. Which contract does each prefer? A

Transcribed Image Text:

Low Demand High Demand Low Effort 20 40 Medium Effort High Effort 40 80 80 100