Consider the following game describing the agency problem between a supervisor and a labourer. Each player has two strategies. The labourer can either work or shirk, and the supervisor can either monitor the labourer or not monitor. If the labourer works, he produces output valued by the supervisor at v, but if he shirks, the value to the supervisor of the labourer’s output is 0. The labourer earns a wage w unless he is caught shirking, in which case the labourer earns 0. Of course, this wage is a cost –w to the supervisor. The labourer experiences disutility from working which reduces his wage by g. Whenever the supervisor monitors the labourer, she incurs a cost h.

(a) Write out a payoff matrix which summarizes the strategies and payoffs for each player in this game.

(b) Find each player’s best-response strategy, given the strategy played by his/her opponent. Does either player have a dominant strategy?

(c) Is there a Nash equilibrium (in pure strategies) in this game? Is this game similar to any of the examples of Section 5.4?