The local government has hired someone to undertake a public project. If the project fails, it will lose $20,000. If it succeeds, the project will earn $100,000. The employee can choose to ‘‘work'' or to ‘‘shirk.'' If she shirks, the project will fail for sure. If she works, the project will succeed half of the time but will still fail half of the time. The employee's utility is $10,000 lower if she works than if she shirks. In addition the employee could earn $10,000 in another job (where she would shirk). The government is choosing whether to pay the employee a flat wage of $20,000 (no matter how the project turns out) or performance-related pay under which the employee earns $0 if the project fails and $40,000 if it succeeds.
a. Assuming both parties are risk neutral, which compensation scheme should the government use?
b. Do you see any problem with the performance-related pay scheme when the employee is risk averse?