A restaurant is either profitable (with profit of $100) or unprofitable (with zero profits) and the outcome of profits is observable to the owner of the restaurant.

The owner hires a manager to run the restaurant. The manager can choose high () or low effort () into running the restaurant. High effort costs more to the manager than low effort.

The probability that the restaurant is successful and makes positive profits depends on the manager's effort but is not completely determined by it. So even if the manager puts in high effort it is possible for the restaurant to make zero profits and conversely positive profits can be realized even if the manager puts in low effort. However, the probability of making positive profits () is higher when the manager puts in high effort than when he puts in low effort.

The following table describes the probability of success, p and effort costs, C for each type of effort.

High Effort, H Low Effort, L

0.8 0.4

$2 $0

The manager is risk neutral and his next best employment pays $10 (this is known as the reservation wage.)

Observable Effort

a) Suppose the owner could observe the manager's effort correctly, describe the wage contract that the owner would choose for the manager.

b) What effort level will the manager choose under this wage contract?

c) What is the restaurant owner's expected profit?

d) Is the outcome efficient?

Unobservable Effort

Now suppose the owner cannot observe effort.

e) If the owner continued to offer the wage contract in part a), what effort level

would the manager choose? What are the expected profits to the restaurant with this wage contract?

Suppose the wage contract was contingent on profits that are realized after the manager has exerted effort.