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TOPICS IN DEVELOPMENT ECONOMICS

ECON 30451

Tutorial 2

1. Consider the interaction between a landlord and a tenant . If the tenant puts in high effort, he will generate revenue R=300 with probability 0.1 and R=800 with probability 0.9. If the tenant puts in low effort, he will generate R=300 and R=800 with equal probability of 0.5. The landlord’s final utility is the revenue R, less the transfer he pays to the tenant. The tenant’s final utility is the transfer paid to him by the landlord, less the cost of his effort. Low effort has a cost of 0, and high effort has a cost of 75 to the tenant. Assume that the tenant’s reservation utility (the level of utility below which the tenant will not accept the job) is equal to 250.

(a) If the landlord offers a fixed wage contract equal to the reservation utility, solve for the payoffs to the landlord and the tenant.

(b) Now assume that the landlord offers a wage linked to the revenues generated. If the wage paid in case of low revenues (R=300) is equal to 100, what is the minimum wage that the landlord has to pay in case of high revenues (R=800) in order to meet the reservation utility of the tenant?

(c) Given the incentive scheme in (b), will the tenant exert high effort?

(d) Show that the incentive scheme in (b) will give the landlord a higher payoff than the fixed wage contract in (a).