optimal contract with monitor Consider a setting where labor input of L or H leads to uneertain output. The owner is risk neutral. Output ean be Xl or X2• The labor suppIier is modeled in the usual fashion, i.e., risk averse with constant risk aversion and with a personal cost of input supply. Let the risk aversion parameter be r = .0001, eH = 5,000 and

Also assume the suppIier's next best alternative offers a certain equivalent of M =

7,000. The output probabilities are Iisted below.

Input H is desired throughout the exereise.
a] Determine an optimal pay-for-performance arrangement.
b] Now suppose a monitor is also available. It will report good (g) or bad (b)
news, at the same time the output is obseIVed. The joint probabilities, conditional on the suppIier's labor input, are:
input H input L b;xI .1 .4 g;xI .2 .3 b;x2 .3 .2 g;x2 .4 .1.

Without solving for an optimal contraet, rank the four possible evaluations from most to least favorable.
e] Determine an optimal pay-for-performance arrangement.
d] Carefully explain the connection between this exereise and that in problems 11 and 12 of Chapter 18.AppendixLO1

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X1 input H .3 input L .7 273 .7 .3