employee farms and applies effort,

employes's outside option is 0 , andemployee has wealth w

Thecompany cannot observee

Effort is costly. The cost of effort is 1/2ce^2

Two things can happen:

With probability : Output is H

With probability : Output is 1-e output is zero

company to employee

Payment of h if output is H

Payment of l if output is 0

max, P(e)= eH+(1e)0 1/2c.e^2

such that

question:

company A optimal e ( can call this Ec)

answer:

H/c = Ec

question:

set up employee utility maximization problem and find his chosen level of effort. Call thisand express it as a function ofh l c

answer:

(h-l)/c= et

question:

max h,L[eH+(1e)0(eh+(1e)L)]

such that

e argmaxeh+(1e)L1/2ce^2 ,

(eh+(1e)L1/2ce^2>=0)

question:

Solve for h andL in terms of H and c . To do so, plug your answers to Q3 and Q4 into the two constraints inQ5 and solve.

P(e) = e*h + (1-e)*L (employee maximises his pay off)

Q4 answer H = h-L