Contract Theory (Summer 18) 3-1 Prof. Dr. Klaus M.

Schmidt

Problem Set 3

Please hand in your individual solutions on Monday, April 30, before

class. Don’t forget to keep a copy of your solutions for yourself! At most
one problem set may be handed in late.

Question 1
(Final Exam 03/04) The risk neutral company “Microhard” wants to employ
a risk neutral programmer. If the programmer works the amount of time t
per week Microhard profits increase by π(t) = t. The programmer has a
cost function
c(t, θ) = θt2 ,
where the parameter θ ∈ { 14 , 12 } is private knowledge of the programmer.
“Microhard” estimates that the probability of low costs (θ = 14 ) is p and
that the probability of high costs (θ = 12 ) is (1 − p). The programmer has an
outside option of U = 0 and Microhard can commit to a “Take-it-or-leave-it”
offer of a menu of possible contracts. Each contract i specifies the weekly
working time ti and a corresponding total wage wi .

a) Derive the first best working time for each type of programmer and
show how a social planner could achieve it by a simple wage scheme.

b) State the problem of the profit maximizing company and explain briefly
why we can restrict the analysis to direct mechanisms.

c) Show which constrains must be binding in the optimum and which

constraints can be ignored.

d) Derive the optimal incentive contract.

e) Let p = 12 . Calculate Microhard’s and the programmer’s profits under

the optimal incentive contract conditional on θ.

f) Under which circumstances would Microhard like to renegotiate ex

post the signed contract from part d)?

g) Describe intuitively the consequences if Microhard cannot credibly

commit not to renegotiate the signed contract.
Contract Theory (Summer 18) 3-2 Prof. Dr. Klaus M. Schmidt

Question 2
Consider a monopolist faced with a continuum of consumers indexed by θ ∈
[θ, θ]. Each consumer is characterized by a thrice continuously differentiable
utility function given by
1
U (q, x | θ) = θq − q 2 + x ,
2
where x is the quantity consumed of good 1 (a numeraire good) and q is the
quantity consumed of good 2 (the good produced by the monopolist).
The parameter θ specifies the consumer’s tastes (known only to him) for
good 2. Assume that θ is uniformly distributed on [θ, θ] and that θ − θ = 1.
The consumers are endowed with a sizable amount of good 1, x, so that
their behavior is always characterized by their first-order conditions. The
monopolist has a linear cost function given by C(q) = c · q.

a) Let q F B (θ), θ ∈ [θ, θ], be the consumption profile that corresponds to

an interior first best efficient allocation. Show that q F B (·) is increasing
in θ.

b) Let {q(θ), t(θ)} be a differentiable revelation mechanism that induces

consumer θ to reveal his type truthfully. More precisely, if he an-
nounces θ, he receives a quantity of q(θ) of good 2 and must pay an
amount t(θ) of good 1. Moreover, assume that the monopolist must
guarantee to each consumer a positive increment in utility given by
1
θq(θ) − q(θ)2 − t(θ) ≥ 0 ∀θ ∈ [θ, θ] .
2
Characterize the set of implementable allocations subject to this con-
straint.

c) Write the optimization program for the monopolist who maximizes

expected profits and who is required to supply his product to all con-
sumers. Show that the optimal profile q ∗ (θ) is increasing in θ. Inter-
pret the optimal revelation mechanism as a nonlinear pricing scheme.
Contract Theory (Summer 18) 3-3 Prof. Dr. Klaus M. Schmidt

Question 3
Air Shangri-la is the only airline allowed to fly between the islands of
Shangri-la and Nirvana. There are two types of passengers, tourists and
business. Business travelers are willing to pay more than tourists. The air-
line, however, cannot tell directly whether a ticket purchaser is a tourist or
a business traveler. The two types do differ, though, in how much they are
willing to pay to avoid having to purchase their tickets in advance. (Passen-
gers do not like to commit themselves in advance to traveling at a particular
time.)
More specifically, the utility levels of each of the two types net of the price
of the ticket, P , for any amount of time W prior to the flight that the ticket
is purchased are given by

Business : uB (P, W ) = v − θB P − W,
T ourist : uT (P, W ) = v − θT P − W,

where 0 < θB < θT and (P, W ) ∈ R2+ . The outside option of not buying a
ticket is 0 for both types.
The proportion of travelers who are tourists is λ. Assume that the costs
of transporting a passenger is c, where c < v/θT , and that there are no
capacity constraints.

a) Formulate the optimal (profit-maximizing) price discrimination prob-

lem mathematically that Air Shangri-la would want to solve.

b) Show that in the optimal solution, tourists are indifferent between

buying a ticket and not going at all.

c) Show that in the optimal solution, business travelers never buy their
ticket prior to the flight (i.e., WB = 0) and that they are just indifferent
between doing this and buying when tourists buy. Do not try to solve
the full program to show this!

d) Show that in the optimal solution, tourists will strictly prefer to buy
a tourists ticket rather than a business ticket (if there is a separating
contract, i.e.).

e) Now fully solve for the optimal price discrimination scheme. How
does it depend on the underlying parameters λ, θB , θT , and c? Under
what circumstances will Air Shangri-la choose to serve only business
travelers?