There is information asymmetry in a "principal and agent relationship". Principal is the main entity whose interests should be realized. An agent should work for the interest of the Principal. This kind of relationship is widespread. For a corporation, shareholder is principal, and manager is its agent. For medicine, patient is principal and medical profession is its agent. For legal service, client is principal and lawyer is its agent. There is differences of information across principal and agent. For a corporation, compared with principal (shareholder), manager has more information on its business, Information of business is "hidden" for the principal. Also activity of manager is not known by principal. Action of manger is "hidden" for principal. Information asymmetry is defined as "hidden information" or "hidden action" in the framework of principal and agent relationship.

Assume a principal and agent relationship of Firm A. Performance and income of shareholder depends both on the fact that whether manager makes efforts or not, and the economic condition in terms of "good" or "bad". Manager himself know if he makes efforts or not, which action is "hidden" to shareholder. After one year, there are four possible outcomes. In case a manager makes efforts, the firm can earn 20 million USD when economic condition is bad, and 40 million USD when it is good. In case a manager does not make effort, the firm can earn 10 million UDS when economic condition is bad, and 20 USD when economic condition is good. For a manager to make effort, 5 million USD equivalent cost should be associated with the effort. Possibility of good economic condition and bad economic condition is half and half.

a. Assume shareholder provide 5 million fixed salary for this manager, does it induce a manager to make effort? In that case, what is the manager's income of salary net of effort cost. What is the shareholder's income as the firm income net of payment for a manager?

b. To maximize the shareholder's income, what salary should be designed? Assume the bonus depending on firm performance.