Consider a contracting environment where the principal is a monopoly and he has incomplete information about any agent he considers employing. An agent's utility function is given by, where agent's effort can take two values e_H=2e and e_L=e for some

e > 0.

The agent has a reservation utility,. If the agent puts high effort, e_H, the probability of a high return state is 0.8 where as If the agent puts low effort, e_L, the probability of a high return state is 0.4. Suppose the principal earns 200 in the high return state and 50 in a low return state.

Required:

a)Solve for the optimal contracts for low and high effort as function of e.

(15 marks)

b)For which values of e does the principal prefer high effort and for which values of e does the principal low effort?