Moral Hazard. A worker can choose either high or low level of effort. The cost of high level is 1, the low level does not cost anything. If the agent chooses the high (low) level, principal gets π with probability pH (pL) and zero otherwise. The agent’s reservation utility is zero. The principal can offer the agent a contract contingent on the principal’s payoff. The agent’s utility of monetary payments is U(x) = ( x, if x > 0; 1.5x, if x < 0, (1) (a)
Find the first best level of effort. (b)
Assume that the effort is not observable. Find the optimal contract. For which parameter values does it implement first best?