lecture 12

Question 1

how do you set up a work contracct as a game?

Answer 1

Players: worker and owner (the firm)
Actions (strategies):
* The owner chooses a wage
* The worker chooses effort level in response to the wage offered
Payoffs:
* Owner: profit from the firm
* Worker: wage minus the cost of effort
The game is sequential and repeated in each period of employment

Question 2

why is effort not verifiable?

Answer 2

• not entirely visible by the firm
• cannot write a contract where the wage depends on the effort level

Question 3

if higher effort levels give workers more disutility, why won’t workers slack off all the time?

Answer 3

• firm may observe output
• output level can be used to infer the effort level
• firm can fire a worker (increased effort reduces the likelihood of getting fired)
• how much a worker will care about losing her job will depend on her employment rent

Question 4

how do you solve the game?

Answer 4

Timeline:
- Owner proposes a contract (wage)
- Worker accepts it or not
- Worker chooses the effort level (taking into account that low effort may lead to job loss)
The game is sequential and repeated in each period of employment
Solve the sequential game using backwards induction
- find the worker’s best response for each possible wage offer

Question 5

what is the firms side?

Answer 5

• wants to maximize profits or minimize the costs of production
• so seh proposes a work contract with an hourly wage to maximize profits
• The firm will take into account that workers respond to higher wages by putting in more effort at
  work (so it may not be optimal for the firm to offer workers the lowest possible wage)

Question 6

what is the firms objective function?

Answer 6

profits = revenues - costs

Question 7

what is a firm’s isoprofits lines?

Answer 7

slope → MRS
it is when the level of profits is constant
The firm is indifferent between all points on the same isoprofit line, because as all of them have the same profits

Question 8

what is the optimal wage?

Answer 8

The firm does not pay the lowest
wage possible
* It needs to pay more to elicit effort
from the worker
* This will give the worker an incentive to put in some effort at work

Question 9

what is the efficiency wage?

Answer 9

it is when higher wages motivate higher worker efficiency, that is, higher effort per hour

Question 10

what happens if the unemployment rate changes?

Answer 10

The worker’s best response curve
depends on the unemployment rate

Question 11

what happens if the unemployment rate increases?

Answer 11

• the worker’s best response curve shifts up
• For a given wage, the worker is willing to put more effort at work
• Optimal wage will decrease
• profits will increase

Question 12

what happens if unemployment benefits increase?

Answer 12

• The worker’s best response curve
  depends on the value of unemployment benefits
• the worker’s best response curve shifts down (to the right)
• For a given wage, the worker is willing to put less effort at work
• Optimal wage will increase
• Profits will decrease