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The effort level E of an employee cannot be observed by the employer but it is known that it leads to the employer's additional profit of 8E with...

20. The effort level E of an employee cannot be observed by the employer but it is known that it
leads to the employer’s additional profit of 8E with probability 0.2 and to zero additional profit
with the complementary probability.
a. Discuss the type of interaction, described in this question, and the resulting problems
from the managerial point of view.
b. Design a wage-bonus package (w,b) for this employee, which maximizes the expected
additional profit of the employer, if the expected utility function of the employee takes
the form u = w + b*1.6E – E*E – 0.2. Note that the bonus b specifies the proportion of
the additional profit that accrues to the employer. The wage w is paid independently of
the amount of the additional profit.
c. Given the optimal wage-bonus package, compute this employees’ effort, expected payoff
and employer’s profit.
d. Draw a game tree for the employer-employee game in parts a-c.

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