Deck 20: Contracts and Moral Hazards

Question 1

Production efficiency implies that

A) joint profits are maximized.
B) joint profits are minimized.
C) joint profits are zero.
D) joint profits can be increased.

Answer 1

joint profits are maximized.

Question 2

In which of the following contracts is the agent's payment unaffected by his performance?

A) fixed-fee contract
B) hire contract
C) contingent contract
D) sharing contract

Answer 2

fixed-fee contract

Question 3

Moral hazard occurs when contracts are written in such a way that

A) the interests of agent and principal converge.
B) the interests of agent and principal diverge.
C) agents will wish to maximize the principal's utility.
D) production and risk-bearing efficiency are achieved.

Answer 3

the interests of agent and principal diverge.

Question 4

The outcome of the state of nature effects the payoff to the agent under a

A) fixed-fee contract.
B) hire contract.
C) contingent contract.
D) All of the above.

Question 5

In NASCAR,a race winner might win,say,$500,000,whereas second place wins $450,000.Why might NASCAR have a 10% reduction in prize money from first and second place?

A) To ensure that there is enough money to pay those who finish near last.
B) To motivate drivers to take risks they might not otherwise take.
C) To motivate drivers to not take risks they might otherwise take.
D) NASCAR is a cartel.

Question 6

Many professional sports athletes have incentive clauses in their contracts.These indicate that

A) the team owner has asymmetric information.
B) the athlete might engage in moral hazard, which the team owner wishes to avoid.
C) the athlete might engage in adverse selection, which the team owner wishes to avoid.
D) the athlete has stronger negotiators.

Question 7

In a store that sells souvenirs,suppose an agent receives a $1 commission for each unit sold,and the principal receives the residual profit.As a result,

A) joint profit is maximized.
B) the agent will sell until the principal's marginal cost equals $1.
C) no agent would enter into such a contract.
D) the agent wishes to sell as many units as he can.

Question 8

A key aspect of the principal-agent problem is that

A) the principal cannot perfectly monitor the agent's actions.
B) the principal can perfectly monitor the agent's actions.
C) the output level does not depend on the agent's actions.
D) the principal is always risk averse.

Question 9

Production inefficiency is most likely to occur when the principal has more information about work performance than the agent does.

Question 10

Season tickets entail a certain amount of risk due to unpredictable team quality,injuries,weather,and so forth.Who is most likely to purchase season tickets?

A) Sally, who is a rabid fan and is not wealthy
B) Jim, who is a rabid fan and is risk neutral
C) Roger, who is a rabid fan but is risk averse
D) Jenn, who is a fan and is very wealthy

Question 11

The type of contract selected depends on the information available to the parties.

Question 12

We can say that a contract is able to prevent moral hazard when

A) it eliminates production inefficiencies due to moral hazard without shifting risk to risk-averse people.
B) it eliminates production inefficiencies due to moral hazard without shifting risk to risk-loving people.
C) it shifts risk to risk-loving people.
D) it eliminates production inefficiencies due to moral hazard and shifts risk to risk-averse people.

Question 13

Suppose an agent must pay the full marginal cost for an item but splits the marginal revenue with the principal.As a result,

A) joint profit is maximized.
B) joint profit is not maximized.
C) the agent will not enter into such a contract.
D) the agent wishes to sell as many items as he can.

Question 14

In professional golf,a tournament winner might win,say,$1 million,whereas second place wins only $600,000.Why might golf have a 40% reduction in prize money from first and second place?

A) To ensure that there is enough money to pay those who finish near last.
B) To motivate golfers to take risks they might not otherwise take.
C) To motivate golfers to not take risks they might otherwise take.
D) The Professional Golfers Association is a cartel.

Question 15

Describe the characteristics of an efficient contract between a principal and an agent.

Question 16

What is one potential problem with nationalized health care?

A) It might not be efficient in risk bearing.
B) It is guaranteed to solve the principal-agent problem.
C) It would be efficient in risk bearing.
D) It might cost too much.

Question 17

Season ticket holders often purchase their tickets before a season begins.There is often a discount associated with season tickets.Why?

A) Buying season tickets entails risk, which consumers are willing to bear if they are compensated for doing so.
B) Buying season tickets is a way of guaranteeing a supply of tickets for the secondary market.
C) Selling season tickets entails greater transactions costs which team owners hope to avoid.
D) Sports teams are local monopolies.

Question 18

Explain how more than one possible state of nature affects contract choices.

Question 19

Efficiency in risk bearing implies that

A) risk is completely eliminated.
B) the least risk-averse party bears most of the risk.
C) the most risk-averse party bears most of the risk.
D) all of the risk is borne by just one of the parties regardless of the degree of risk aversion.

Question 20

An efficient contract is an agreement in which

A) neither party can be made better off without harming the other party.
B) both parties agree on its clauses.
C) one party takes all.
D) both parties agree to always do their best.

Question 21

In a principal-agent problem,if the contract implies that the more risk-averse agent will bear less risk,we can say that this contract exhibits

A) efficiency in risk-bearing.
B) risk sharing is not optimal because the less risk-averse (or risk-neutral) agent should bear none of the risk.
C) risk sharing is not optimal because all risk should be transferred to the most risk-averse agent.
D) risk sharing is not optimal because risk-neutral agents should face no risk.

Question 22

In the presence of asymmetric information,

A) all contracts are efficient.
B) efficiency in risk bearing cannot be achieved.
C) a trade-off exists between risk-bearing efficiency and production efficiency.
D) no contracting will take place.

Question 23

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid a fixed fee.Under this contract,

A) production efficiency is achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.

Question 24

In the presence of asymmetric information,the only contract that results in production efficiency and no moral hazard is the one in which

A) the agent receives a fixed fee.
B) the principal receives a fixed rent.
C) profit is shared.
D) revenue is shared.

Question 25

If the principal has full information,production efficiency without supervision can occur with

A) a fixed fee rental contract.
B) a profit-sharing contract.
C) an incentive-compatible contract.
D) All of the above.

Question 26

In the presence of asymmetric information,a contingent contract

A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Question 27

In the presence of asymmetric information,a hire contract

A) achieves production efficiency.
B) can lead to opportunistic behavior on the part of the agent.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Question 28

In the presence of asymmetric information,a piece-rate contract

A) achieves production efficiency.
B) can lead to agents producing more output than would occur under a fixed-rent-paid-to-the-principal contract.
C) is impossible to write.
D) will result in the principal earning all of the profit.

Question 29

Suppose a plaintiff hires a lawyer to represent her in a court case.She agrees to pay the lawyer a wage per hour.She knows precisely what the lawyer should do and how long each activity should take,and she can verify that the lawyer has correctly completed each activity.She can terminate the contract at any time.With this contract,

A) the lawyer bears all the risk.
B) the risk is shared by the lawyer and the plaintiff.
C) production efficiency can be achieved.
D) production efficiency is impossible.

Question 30

Suppose a plaintiff hires a lawyer to represent her in a court case.To which of the following contracts would a highly risk-averse plaintiff agree?

A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.

Question 31

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will be paid by the hour.Under this contract,

A) production efficiency is not achieved.
B) the client bears all of the risk.
C) the lawyer has an incentive to lie about his hours worked.
D) All of the above.

Question 32

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is production efficiency assured?

A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) The lawyer pays the client a fee for the right to the entire settlement.

Question 33

Under which one of the following conditions would a lawyer accept a case on a contingent basis?

A) The lawyer is risk averse.
B) The client is risk loving.
C) The lawyer has several cases on a contingent basis with payoffs that are not perfectly positively correlated.
D) The lawyer is more risk averse than the client is.

Question 34

Under which one of the following contracts does an agent have the least incentive to behave opportunistically?

A) The agent pays a fixed fee to the principal for the right to all future payoffs.
B) The agent works for the principal on an hourly basis.
C) The agent receives a share of the profit.
D) The agent works for the principal on a per unit basis.

Question 35

Suppose a plaintiff hires a lawyer to represent her in a court case.The lawyer will receive a share of the settlement if the plaintiff wins.Under this contract,

A) production efficiency cannot be achieved.
B) the client bears all of the risk.
C) the lawyer bears all of the risk.
D) the risk is shared.

Question 36

Suppose two owners of a store agree to split the profit equally regardless of the number of hours each spends working at the store.As a result,

A) production efficiency is achieved.
B) each enjoys only half the marginal benefit of an additional hour working in the store.
C) one will work all of the time while the other works zero hours.
D) each will work as many hours as if he or she were the sole owner.

Question 37

Suppose a plaintiff hires a lawyer to represent her in a court case.Under which of the following contracts is efficiency in risk bearing assured?

A) The lawyer is paid by the hour.
B) The lawyer receives a share of the settlement.
C) The lawyer receives a fixed fee.
D) It is impossible to determine without the degree of risk aversion for each.

Question 38

In a principal-agent problem,if the contract used leads to the maximum of the principal's and agent's combined value (profits,payoffs),we can say that this contract features

A) inefficiency in production, since only the principal's profits should be maximized.
B) inefficiency in production, since only the agent's payoffs should be maximized.
C) efficiency in production.
D) inefficiency in production, since the agent's payoffs should be maximized and the principal's profits should be minimized.

Question 39

Sue offers to pay Al $50 for each painting of his that she sells in her gallery.Each painting sells for $75.The cost to Al of producing each painting is $55.Which of the following statements is TRUE about this contract?

A) This contract is efficient.
B) This contract maximizes joint profit.
C) Al will not participate in this contract.
D) This is a fixed-fee contract.

Question 40

Suppose the principal offers to share a percentage of the profit with the agent.Such a contract

A) will yield the same income for the agent as a hire contract would.
B) is incentive compatible.
C) creates a production inefficiency.
D) would not be acceptable to any agent.

Question 41

If an agent is risk neutral and a principal is risk averse,which of the following contracts would be efficient in risk bearing?

A) A fixed fee is paid to the agent.
B) A fixed fee is paid to the principal.
C) An hourly rate is paid to the agent.
D) The agent enjoys a share of the profit.

Question 42

Author A accepts a $5,000 advance and a 10% royalty after 5,000 books are sold.Author B foregoes the advance and negotiates for a 15% royalty on all books sold.Author C decides to self publish his book and keep 50% of all sales revenue.Which of these authors expects to sell the fewest books?

A) Author A
B) Author B
C) Author C
D) They are all equally likely.

Question 43

A contingent contract can create production inefficiency; however,many principals accept this because

A) inefficiency is inevitable.
B) monitoring is costless.
C) risk is reduced.
D) profit will increase as a result.

Question 44

In the presence of asymmetric information with costless monitoring and enforcement,a hire contract results in production efficiency.

Question 45

Rents for stores at shopping malls are usually tied to the profits of the store.Comment on how this arrangement affects the mall owner's income versus a fixed rent.

Question 46

Sam is suing someone in court for $10,000.The probability that Sam will lose the case is 1/h where h is the number of hours that Sam's attorney works on the case.The lawyer charges $500 per hour if he is to be paid hourly,or he requests 20% of the settlement if he is to be paid on a contingency basis.Assuming both Sam and the attorney are risk-neutral wealth maximizers,is either contract efficient?

Question 47

One reason that lawyers might prefer a contingent contract when representing a plaintiff in a tort case is that

A) lawyers are risk neutral.
B) diversification of many cases allows lawyers to reduce risk.
C) lawyers are typically confident about winning every case.
D) hourly rates for lawyers are usually very low.

Question 48

Profit-sharing contracts are designed to

A) mitigate the moral hazard problem.
B) be fair with the workers.
C) be used in situations in which shirking is not possible.
D) All of the above.

Question 49

Author A accepts a $5,000 advance and a 10% royalty after 5,000 books are sold.Author B foregoes the advance and negotiates for a 15% royalty on all books sold.Author C decides to self publish his book and keep 50% of all sales revenue.In what order of risk aversion (from most to least)would you rank these authors?

A) Author A, Author B, Author C
B) Author A, Author C, Author B
C) Author B, Author A, Author C
D) Author C, Author B, Author A

Question 50

If information is asymmetric,explain why the hire contract is not efficient in production and a moral hazard exists,but the fixed fee to the principal contract is efficient and does not pose a moral hazard problem.

Question 51

If a firm has established monitoring devices that have a 50% chance of detecting shirking,and an employee gains $5,000 from shirking,the employer can deter shirking by having employees post a bond equal to

A) $2,500.
B) $5,000.
C) $10,000.
D) $50,000.

Question 52

Author A accepts a $5,000 advance and a 10% royalty after 5,000 books are sold.Author B foregoes the advance and negotiates for a 15% royalty on all books sold.Author C decides to self publish his book and keep 50% of all sales revenue.Which of these authors is most likely to have 10 books published?

A) Author A
B) Author B
C) Author C
D) They are all equally likely.

Question 53

Many art galleries keep 60% of the sale price of a painting.However,art galleries do not typically pay the artist while the painting hangs on the wall.This form of contingency contract may be efficient if

A) the artist is less risk averse than the gallery.
B) the gallery is less risk averse than the artist.
C) the artist is unable to diversify across galleries or paintings.
D) the gallery is unable to diversify across artists of paintings.

Question 54

Sam hires an attorney to present a court case.If Sam wins the case,he will receive some money.This payoff is a function of the attorney's hours and which judge is assigned the case that day.Judge A is very understanding toward people in Sam's position,but judge B is very harsh toward people like Sam.Is it possible for Sam to get the attorney to deliver the optimal amount of effort and make the attorney bear all of the risk?

Question 55

When is a piece-rate contract generally used?

A) It is used when output but not labor can be observed.
B) It is only used to avoid adverse selection.
C) It is used when labor but not output can be observed.
D) It is never used in practice.

Question 56

Assume a lawyer signs a contingency fee contract with a plaintiff.The case ends up settling for $1 million,of which the plaintiff received $800,000.It is obvious this contract was efficient.

A) True, the plaintiff received some money.
B) False, it is not clear whether another lawyer would have settled for more.
C) False, it is not clear whether the plaintiff's lawyer is very smart.
D) True, the plaintiff and lawyer reached an agreement and both lived up to their end of the agreement.

Question 57

With full information any contract will lead to production efficiency.

Question 58

In the presence of asymmetric information,production efficiency is assured when the principal and agent share the profit.

Question 59

Sarah's demand for routine medical visits is q = 10 - 0.2p when she is healthy and q = 20 - 0.2p when she is sick.Medical visits cost $50 each if Sarah has no medical insurance.She is sick 20% of the time.Sarah is considering two different insurance plans.One offers free medical visits; the other plan costs less up front but requires that Sarah pay $5 per medical visit.Compare the two plans in terms of the trade-off between risk and moral hazard.

Question 60

Shay is risk averse and has a reservation wage of $50.She is offered two different labor contracts.One is a fixed wage of $100 per day,and the other is a piece-rate contract.In the latter,the pay rate is $1 per piece.In a good day she sells 160 units,and in bad day she sells 40 units.The likelihood of a good or a bad day is 50%.

A) Shay accepts the fixed wage contract.
B) Shay declines both contracts.
C) Shay accepts the piece-rate contract.
D) Shay is indifferent between both contracts.

Question 61

If all firms pay an efficiency wage,then

A) there is no cost to shirking because the shirking worker can receive his high wage at another firm after being caught and fired.
B) the macroeconomy would enjoy a prolonged period of near-zero unemployment.
C) there is a cost to shirking because the efficiency wage is less than it would have been if only a few firms paid it.
D) there is a cost to shirking because the shirking worker will spend a greater time unemployed after being caught and fired.

Question 62

In 2008,foreclosures reached a record high.Which of the following is NOT a possible reason for foreclosures?

A) Many mortgages were initiated without a down payment.
B) Many mortgages were initiated on secondary and investment homes.
C) Some mortgages were adjustable rate mortgages which might have dramatically increased monthly payments for some.
D) Property values were increasing too fast.

Question 63

A profit-maximizing firm that uses an efficiency wage and monitors will increase the wage it pays its workers until

A) the worker requires no monitoring.
B) the worker receives the market wage and requires full-time monitoring.
C) the cost of monitoring the worker equals the efficiency wage.
D) the change in the workers' productivity from being monitored times the per time unit cost of monitoring equals one.

Question 64

An efficiency wage premium serves the same function as a bond because,just as with a bond,the premium represents

A) the amount the employee loses if caught shirking.
B) the expected value of the amount the employee loses if he shirks.
C) the cost of monitoring the employee.
D) the gain to the employee if he shirks.

Question 65

A firm uses an efficiency wage scheme to deter workers from shirking.A risk-neutral worker will NOT shirk if

A) the expected loss from being fired is larger than or equal to the gain from shirking.
B) the expected loss from being fired is smaller than the gain from shirking.
C) the gain from shirking is positive.
D) the expected loss from being fired is zero.

Question 66

A firm uses an efficiency wage scheme to deter workers from shirking.Suppose a risk-neutral worker that has a reservation wage of $1000.The industry ongoing wage is $2,000.The efficiency wage paid by this firm is $7,000.What is this firm's shirking detection rate?

A) 5%
B) 20%
C) 10%
D) 25%

Question 67

A major problem inherent in posting bonds is that

A) workers are not trustworthy.
B) workers may not have enough wealth to post them.
C) workers cannot find co-signers.
D) All of the above.

Question 68

As the probability of detecting shirking increases,the size of the bond necessary to deter shirking

A) also increases.
B) stays the same.
C) decreases.
D) increases at an exponential rate.

Question 69

An employee gains $500 from shirking.Thus,to deter shirking,the employer makes employees post a bond equal to $1,000,and installs monitoring devices to detect shirking.What is the probability that these devices can detect shirking?

A) 30%
B) 100%
C) 50%
D) 95%

Question 70

Monitoring is often used by firms in an attempt to decrease

A) shirking.
B) piece rates.
C) adverse selection.
D) signaling.

Question 71

Which of the following workers is most likely to be asked to post a bond?

A) construction contractor
B) fast food worker
C) sanitation worker
D) book author

Question 72

A firm uses an efficiency wage scheme to deter workers from shirking,which is detected 10% of the times.Suppose a risk-neutral worker that has a reservation wage of $500.The efficiency wage paid by this firm is $7,000.What is the industry ongoing wage?

A) $1,000
B) $5,000
C) $1,500
D) $2,000

Question 73

If a professional sports athlete signs a new contract which defers compensation until years after she is retired,she is signaling

A) that she does not plan to shirk in the future, regardless of whether she did so in the past.
B) that she did shirk and she will do so in the future.
C) that she did shirk but won't do so in the future.
D) that she didn't shirk and she won't do so in the future.

Question 74

A firm uses an efficiency wage scheme to deter workers from shirking,which is detected 10% of the times.Suppose a risk-neutral worker that has a reservation wage of $500.The industry ongoing wage is $1000.What is the efficiency wage paid by this firm?

A) $6,000
B) $5,000
C) $1,500
D) $2,000

Question 75

Explain why a firm may hire managers to operate outlets near the firm's headquarters,but may sell franchise rights for the outlets located greater distances from the headquarters.(With a franchise,the firm sells a brand name and a method of doing business to someone who then owns and operates the outlet.)

Question 76

The benefit to employers of deferred payments is that

A) adverse selection is eliminated.
B) employers cannot engage in any opportunistic behavior.
C) these payments raise the cost of being fired, so more monitoring is needed.
D) these payments raise the cost of being fired, so less monitoring is needed.

Question 77

When shirking at the workplace occurs,increased monitoring of workers is the only effective way to reduce this behavior.

Question 78

If an additional dollar spent on monitoring would reduce shirking by 10 minutes,then the firm will increase the worker's wage by $1 if this caused

A) shirking to increase by less than 10 minutes.
B) shirking to decrease by more than 10 minutes.
C) shirking to decrease by less than 10 minutes.
D) monitoring to become unnecessary.

Question 79

Which of the following would NOT be used by firms to deter shirking?

A) requiring employees to post a bond
B) offering a bonus after five years of service
C) paying more than the market wage
D) paying less than the market wage

Question 80

A firm uses an efficiency wage scheme to deter workers from shirking,which is detected 10% of the times.Suppose a risk-neutral worker.The industry ongoing wage is $3,000.The efficiency wage paid by this firm is $8,000.What is this worker's reservation wage?

A) $400
B) $500
C) $1,000
D) $1,500