2. Consider the situation where shareholders hire a CEO to manage a firm. The CEO's utility...

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2. Consider the situation where shareholders hire a CEO to manage a firm. The CEO's utility function is: u(w. e) = u(w)-v(e). where w is wage received, e is effort put in. Assume u' > 0. u" <0. v' > 0, v"> 0, v(0) = 0. v'(0) = 0. Let the reservation utility of the manager be U. This ensures that effort level e > 0. The shareholders' profits are: B(x, w) = px - cx-w. where p is price of the good in the market, x are the sales and c is the constant marginal cost. (a) (10 points) In the full information case, write down the problem for shareholders choosing the optimal contract for the manager. What will be the optimal effort level of the CEO in this case? Discuss the implications of the result. (b) (20 points) If the effort of the CEO is not observable, what will be the maximization problem for the shareholders to determine the optimal contract. How is the optimal contract, w, determined? What is the condition that needs to be satisfied for the determination of the optimal contract and effort level? Discuss how the principles of this contract compare with other optimal contracts when there is moral hazard. 2. Consider the situation where shareholders hire a CEO to manage a firm. The CEO's utility function is: u(w. e) = u(w)-v(e). where w is wage received, e is effort put in. Assume u' > 0. u" <0. v' > 0, v"> 0, v(0) = 0. v'(0) = 0. Let the reservation utility of the manager be U. This ensures that effort level e > 0. The shareholders' profits are: B(x, w) = px - cx-w. where p is price of the good in the market, x are the sales and c is the constant marginal cost. (a) (10 points) In the full information case, write down the problem for shareholders choosing the optimal contract for the manager. What will be the optimal effort level of the CEO in this case? Discuss the implications of the result. (b) (20 points) If the effort of the CEO is not observable, what will be the maximization problem for the shareholders to determine the optimal contract. How is the optimal contract, w, determined? What is the condition that needs to be satisfied for the determination of the optimal contract and effort level? Discuss how the principles of this contract compare with other optimal contracts when there is moral hazard.

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Here we have two budget constraints one for each period while in the usual Walrasian setting we only ... View the full answer