Question 1

In a principal-agent problem,if the contract implies that the more risk-averse agent will bear less risk,we can say that this contract exhibits
A) efficiency in risk-bearing.
B) risk sharing is not optimal because the less risk-averse (or risk-neutral) agent should bear none of the risk.
C) risk sharing is not optimal because all risk should be transferred to the most risk-averse agent.
D) risk sharing is not optimal because risk-neutral agents should face no risk.

Accepted Answer

Efficiency in risk-bearing means that the risk is allocated between the principal and agent in a way that minimizes the total costs of bearing risk. In this case, the contract implies that the more risk-averse agent will bear less risk, which implies that the risk is being allocated efficiently between the principal and agent.

Question 2

In the presence of asymmetric information,
A) all contracts are efficient.
B) efficiency in risk bearing cannot be achieved.
C) a trade-off exists between risk-bearing efficiency and production efficiency.
D) no contracting will take place.

Accepted Answer

Asymmetric information means that one party has more information than the other, which can result in adverse selection or moral hazard problems. In such situations, achieving both risk-bearing efficiency and production efficiency may not be possible, and a trade-off likely exists between the two. Therefore, choice (C) is the best answer. Choice (A) is incorrect because not all contracts are efficient in the presence of asymmetric information. Choice (B) is incorrect because efficiency in risk bearing can be achieved, but not without a trade-off with production efficiency. Choice (D) is incorrect because some form of contracting (even if not perfect) is still likely to take place, despite the presence of asymmetric information.

Question 3

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid a fixed fee.Under this contract,
A) production efficiency is achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.

Accepted Answer

A fixed fee contract places all of the risk on the client, as they are responsible for paying the agreed-upon fee regardless of the outcome of the case. In this scenario, there is no production efficiency or incentive for the lawyer to lie about their hours worked.

Question 4

In the presence of asymmetric information,the only contract that results in production efficiency and no moral hazard is the one in which
A) the agent receives a fixed fee.
B) the principal receives a fixed rent.
C) profit is shared.
D) revenue is shared.

Accepted Answer

The answer of In the presence of asymmetric information,the only...

Question 5

If the principal has full information,production efficiency without supervision can occur with
A) a fixed fee rental contract.
B) a profit-sharing contract.
C) an incentive-compatible contract.
D) All of the above.

Accepted Answer

Production efficiency without supervision can occur with all the mentioned contracts if the principal has full information. A fixed fee rental contract can ensure efficiency by transferring operational decisions to the agent, who then has the incentive to be efficient to maximize their own profit. A profit-sharing contract aligns the interests of the principal and the agent by giving both parties a stake in the profitability of the venture, encouraging efficient production. An incentive-compatible contract is designed specifically to ensure that the agent's incentives are aligned with the principal's objectives, promoting efficiency even in the absence of supervision.

Question 6

In the presence of asymmetric information,a contingent contract
A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Accepted Answer

In the presence of asymmetric information, a contingent contract may lead to opportunistic behavior on the part of the agent. This is because the agent may have more information about their abilities or actions than the principal, and may act in their own self-interest rather than in the best interest of the principal. Hence, while a contingent contract can mitigate information asymmetry to some extent, it is not a foolproof solution and can still result in adverse outcomes.

Question 7

In the presence of asymmetric information,a hire contract
A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Accepted Answer

Asymmetric information occurs when one party in a contract has more information than the other party. In a hiring contract, the employer (principal) may not have complete information about the skills, effort, or intentions of the employee (agent). This can lead to the potential for opportunistic behavior on the part of the agent, such as shirking or misrepresentation of their abilities. Therefore, option B is correct. Option A is incorrect as production efficiency may not be achieved if the agent does not provide their best effort. Option C is incorrect as it is possible to write a hire contract, even with asymmetric information. Option D is incorrect as the principal earning all of the profit is not necessarily a desirable outcome from a societal perspective.

Question 8

In the presence of asymmetric information,a piece-rate contract
A) achieves production efficiency.
B) can lead to agents producing more output than would occur under a fixed-rent-paid-to-the-principal contract.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Accepted Answer

In the presence of asymmetric information, a piece-rate contract can incentivize agents to produce more output than they would under a fixed-rent-paid-to-the-principal contract, as the agents are motivated to increase their earnings. This may lead to higher production efficiency, but it is also possible that the agents may cut corners or sacrifice quality to increase their output. The option of a fixed-rent-paid-to-the-principal contract may not be optimal because it does not incentivize the agents to produce more efficiently.

Question 9

Suppose a plaintiff hires a lawyer to represent her in a court case.She agrees to pay the lawyer a wage per hour.She knows precisely what the lawyer should do and how long each activity should take,and she can verify that the lawyer has correctly completed each activity.She can terminate the contract at any time.With this contract,
A) the lawyer bears all the risk.
B) the risk is shared by the lawyer and the plaintiff.
C) production efficiency can be achieved.
D) production efficiency is impossible.

Accepted Answer

With this contract, production efficiency can be achieved as both parties have a clear understanding of the expected output and the time required for each activity. The plaintiff's ability to verify the completion of each activity provides accountability for the lawyer, which can lead to greater productivity. The ability to terminate the contract at any time also encourages the lawyer to work efficiently to avoid losing the client. The risk is not solely on the lawyer as the plaintiff is paying for the services and can terminate the contract if they are dissatisfied with the lawyer's performance.

Question 10

Suppose a plaintiff hires a lawyer to represent her in a court case.To which of the following contracts would a highly risk-averse plaintiff agree?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.

Accepted Answer

The answer of Suppose a plaintiff hires a lawyer to...

Question 11

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid by the hour.Under this contract,
A) production efficiency is not achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.

Accepted Answer

When a lawyer is paid by the hour, production efficiency is not achieved because the lawyer may not have an incentive to work efficiently, potentially leading to more hours billed than necessary. The client bears all the risk of the case taking longer than expected, increasing their costs. Additionally, the lawyer might have an incentive to overstate the hours worked to increase their compensation, although ethical standards are supposed to prevent this.

Question 12

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is production efficiency assured?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.

Accepted Answer

The answer of Suppose a plaintiff hires a lawyer to...

Question 13

Under which one of the following conditions would a lawyer accept a case on a contingent basis?
A) The lawyer is risk averse.
B) The client is risk loving.
C) The lawyer has several cases on a contingent basis with payoffs that are not perfectly positively correlated.
D) The lawyer is more risk averse than the client is.

Accepted Answer

Lawyers are more likely to accept a case on a contingent basis when they have several cases on a contingent basis with payoffs that are not perfectly positively correlated. This is because the lawyer can diversify their risk and potentially earn higher overall profits. Choosing option A or D is incorrect as it implies being more risk averse, which is not the necessary condition for accepting such cases. Option B is incorrect as it refers to client preferences rather than lawyer preferences.

Question 14

Under which one of the following contracts does an agent have the least incentive to behave opportunistically?
A) The agent pays a fixed fee to the principal for the right to all future payoffs.
B) The agent works for the principal on an hourly basis.
C) The agent receives a share of the profit.
D) The agent works for the principal on a per unit basis.

Accepted Answer

In option A, since the agent pays a fixed fee for the right to all future payoffs, they have a strong incentive to maximize those payoffs, aligning their interests closely with the principal's. This setup minimizes the agent's incentive to behave opportunistically because their earnings are directly tied to the success of the venture, unlike the other options where the agent's compensation is less directly connected to overall performance.

Question 15

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will receive a share of the settlement if the plaintiff wins.Under this contract,
A) production efficiency cannot be achieved.
B) the client bears all of the risk.
C) the lawyer bears all of the risk.
D) the risk is shared.

Accepted Answer

In this type of contract, both the plaintiff and the lawyer share the risk. The lawyer takes on the risk of not being paid if the plaintiff loses the case, while the plaintiff shares the risk of potentially receiving less of a settlement due to the lawyer's fees. Therefore, the risk is shared, and as a result, this contract can still achieve some level of production efficiency.

Question 16

Suppose two owners of a store agree to split the profit equally regardless of the number of hours each spends working at the store.As a result,
A) production efficiency is achieved.
B) each enjoys only half the marginal benefit of an additional hour working in the store.
C) one will work all of the time while the other works zero hours.
D) each will work as many hours as if he or she were the sole owner.

Accepted Answer

When profits are split equally regardless of the hours worked, each owner only receives half the benefit (or marginal benefit) of their additional work, as the other half goes to the co-owner. This can lead to a situation where both are less motivated to work additional hours since the full benefit of their labor is not realized individually.

Question 17

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is efficiency in risk bearing assured?
A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) It is impossible to determine without the degree of risk aversion for each.

Accepted Answer

Efficiency in risk bearing depends on the risk preferences of the parties involved. Without knowing the degree of risk aversion of the plaintiff and the lawyer, it's impossible to determine which contract type assures efficiency in risk bearing. Each contract type (hourly, contingency, fixed fee) allocates risk differently between the lawyer and the client, and the efficiency of these allocations varies with their risk preferences.

Question 18

In a principal-agent problem,if the contract used leads to the maximum of the principal's and agent's combined value (profits,payoffs),we can say that this contract features
A) inefficiency in production, since only the principal's profits should be maximized.
B) inefficiency in production, since only the agent's payoffs should be maximized.
C) efficiency in production.
D) inefficiency in production, since the agent's payoffs should be maximized and the principal's profits should be minimized.

Accepted Answer

If the contract used leads to the maximum of the principal's and agent's combined value (profits, payoffs), it means that both parties have an incentive to work towards this goal, which ultimately increases efficiency in production. This is known as a win-win situation, where both parties benefit from the contract. If the principal's profits were maximized at the expense of the agent's payoffs or vice versa, it would lead to a conflict of interest and a less efficient outcome. Therefore, option C is the correct answer.

Question 19

Sue offers to pay Al $50 for each painting of his that she sells in her gallery.Each painting sells for $75.The cost to Al of producing each painting is $55.Which of the following statements is TRUE about this contract?
A) This contract is efficient.
B) This contract maximizes joint profit.
C) Al will not participate in this contract.
D) This is a fixed-fee contract.

Accepted Answer

Al will not participate in this contract because his cost to produce each painting ($55) is higher than the payment he receives from Sue ($50), resulting in a loss for Al.

Question 20

Suppose the principal offers to share a percentage of the profit with the agent.Such a contract
A) will yield the same income for the agent as a hire contract would.
B) is incentive compatible.
C) creates a production inefficiency.
D) would not be acceptable to any agent.

Accepted Answer

A contract that offers to share the profits with the agent creates an incentive for the agent to work harder and be more productive, leading to higher profits and a higher percentage for the agent. This makes it an incentive compatible contract. However, it may also create a production inefficiency if the agent focuses solely on maximizing profits rather than other factors like quality or customer satisfaction. So, option B would be the best choice. Option A is incorrect because the income earned by the agent will depend on the profits generated, which can be higher or lower than a flat rate hire contract. Option D is incorrect because the contract can be acceptable to an agent if the percentage offered is attractive enough.

Quiz 20: Contracts and Moral Hazards

In a principal-agent problem,if the contract implies that the more risk-averse agent will bear less risk,we can say that this contract exhibits

In the presence of asymmetric information,

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid a fixed fee.Under this contract,

In the presence of asymmetric information,the only contract that results in production efficiency and no moral hazard is the one in which

If the principal has full information,production efficiency without supervision can occur with

In the presence of asymmetric information,a contingent contract

In the presence of asymmetric information,a hire contract

In the presence of asymmetric information,a piece-rate contract

Suppose a plaintiff hires a lawyer to represent her in a court case.To which of the following contracts would a highly risk-averse plaintiff agree?

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid by the hour.Under this contract,

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is production efficiency assured?

Under which one of the following conditions would a lawyer accept a case on a contingent basis?

Under which one of the following contracts does an agent have the least incentive to behave opportunistically?

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will receive a share of the settlement if the plaintiff wins.Under this contract,

Suppose two owners of a store agree to split the profit equally regardless of the number of hours each spends working at the store.As a result,

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is efficiency in risk bearing assured?

In a principal-agent problem,if the contract used leads to the maximum of the principal's and agent's combined value (profits,payoffs) ,we can say that this contract features

Sue offers to pay Al $50 for each painting of his that she sells in her gallery.Each painting sells for $75.The cost to Al of producing each painting is $55.Which of the following statements is TRUE about this contract?

Suppose the principal offers to share a percentage of the profit with the agent.Such a contract