Q. Effort level E of an employee cannot be observed by employer but it is known that it leads to employer's additional profit of 8E with probability 0.2 and to zero additional profit with complementary probability.

a. Discuss type of interaction, described in this question and resulting problems
from managerial point of view.

b. Design a wage-bonus package (w,b) for this employee, which maximizes expected
additional profit of employer, if expected utility function of employee takes
form u = w + b*1.6E - E*E - 0.2. Note that bonus b specifies proportion of
additional profit that accrues to employer. Wage w is paid independently of
amount of additional profit.

c. Provide optimal wage-bonus package, compute this employees' effort, expected payoff and employer's profit.

d. Draw a game tree for employer-employee game in parts a-c.