Discuss a real-world example of a contractual situation with limited verifiability. How do the parties deal with this contractual imperfection? Consider a two-player contractual setting in which the players produce as a team. In the underlying game, players 1 and 2 each select high (H) or low (L) effort.
A player who selects H pays a cost of 3; selecting L costs nothing. The players equally share the revenue that their efforts produce. If they both select H, then revenue is 10. If they both select L, then revenue is 0. If one of them selects H and the other selects L, then revenue is x.
Thus, if both players choose H, then they each obtain a payoff of 1/ 2 .10 - 3 = 2; if player 1 selects H and player 2 selects L, then player 1 gets 1 2 # x - 3 and player 2 gets 1 2 # x; and so on. Assume that x is between 0 and 10. Suppose a contract specifies the following monetary transfers from player 2 to player 1: a if (L, H) is played, b if (H, L) is played, and g if (L, L) is played.
Suppose that there is limited verifiability in the sense that the court can observe only the revenue (10, x, or 0) of the team, rather than the players' individual effort levels. How does this constrain a, b, and g?