Question: Suppose an agent A has a contract with a principal P. The contract is W = a + bX, where a = the base salary,

Suppose an agent A has a contract with a principal P. The contract is W = a + bX, where a = the base salary, b = an incentive parameter and X = output of the firm, which sells for price p. Suppose further that this firm has constant returns to scale and the production function is X = e, where e is a critical input supplied by A. If both the Principal and the Agent are risk neutral, what is the optimal value of b that maximizes total value? What is the economic interpretation of the result?

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