Instructor Manual For
Microeconomics 9th Global
Edition By Jeffrey Perloff
(All Chapters 1-20, 100%
Original Verified, A+ Grade)
All Chapters Arranged Reverse:
20-1
This is The Original Instructor
Manual For 9th Global Edition,
All other Files in The Market are
Fake/Old/Wrong Edition.
,Chapter 20
Contracts and Moral Hazards
Chapter Outline
Challenge: Clawing Back Bonuses
20.1 The Principal-Agent Problem
Efficiency
Symmetric Information
Asymmetric Information
Solved Problem 20.1
Application: Honest Cabbie?
20.2 Using Contracts to Reduce Moral Hazard
Fixed-Fee Contracts
Contingent Contracts
State-Contingent Contracts
Application: Health Insurance and Moral Hazard
Solved Problem 20.2
Profit-Sharing Contracts
Solved Problem 20.3
Application: Sing for Your Supper
Bonuses and Options
Piece Rates
Commissions
Solved Problem 20.4
Choosing the Best Contract
20.3 Monitoring to Reduce Moral Hazard
Bonding
Bonding to Prevent Shirking
Trade-Off Between Bonds and Monitoring
Solved Problem 20.5
Problems with Bonding
Application: Capping Oil and Gas Bankruptcies
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
,347 Perloff • Microeconomics, Ninth Edition, Global Edition
Deferred Payments
Efficiency Wages
How Efficiency Wages Act like Bonds
Efficiency Wages and Unemployment
Application: Wal-Mart’s Efficiency Wages
Monitoring Outcomes
20.4 Checks on Principals
Application: Layoffs Versus Pay Cuts
20.5 Contract Choice
Challenge Solution: Clawing Back Bonuses
ONLINE: Thinking Critically About a Current Event: Splitting Ill-Gotten Gains
Teaching Tips
Chapter 20 continues the discussion started in Chapter 19 on transaction costs. Although it is not necessary
to cover all of Chapter 19 before Chapter 20, it will be helpful if the class is familiar with at least the
introductory portion of Chapter 19. Whereas Chapter 19 concentrated on informational asymmetries with
respect to a participant’s true nature at the time of agreement, Chapter 20 focuses on how incentives
influence behavior once a contract has been agreed upon.
However, the material is not difficult and need not be saved for the end of the semester if you are
interested in including it earlier. For example, one logical place to discuss principal-agent problems is
while covering the factor markets (Chapter 15). By doing so, you can contrast labor markets at the
aggregate level with labor contracts at the individual level.
One of the keystones of the material in this chapter is incentive compatibility. You might suggest to the
class that whenever they are evaluating an individual-level transaction, one of the prerequisites to sound
analysis is to check the incentives of the buyer and the seller. The application on selfless or selfish doctors
is a good way to motivate the discussion. This application should lead the students to think of experiences
they’ve had or heard of in unnecessary dental work or medical tests. By beginning the discussion in this
way, you should be able to lead the class directly to the importance of information and the opportunity for
moral hazard problems to arise when information is asymmetric.
The optimal contract type depends on the level of uncertainty and symmetry of information between buyer
and seller. Possible arrangements include piece rates, fixed fees, hourly rates, and contingent fees. You
might present the class with a number of transactions and ask them to decide what the best type of contract
is. They may find that in many cases, the seller would prefer one type of contract and the buyer another,
and a compromise between efficiency and risk bearing must be sought.
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
, Chapter 20 Contracts and Moral Hazards 348
The text includes an example of Amy and her employer, Paul, and the optimal employment contract.
Another example is a professional athlete and a team owner. The athletes would like for the contract to be
guaranteed, so that no matter what the performance level is, he or she receives payment. Employers
(teams) would prefer to pay employees based on performance. The advantage of sports examples is that
there is a steady stream of stories throughout the year of player negotiations that have reached stalemates
over contract structure.
An extreme example is professional baseball, in which top draft picks demand large contracts (typically in
excess of $8 million) with a good portion guaranteed as a “signing bonus.” These demands come despite
the fact that the drafted players have never played at the major league level. Because of the uncertainty
involved (many top drafted players never succeed at the professional level in baseball), some teams have
been very reluctant to meet players’ demands. In 2009, NBA rookie Ty Lawson was one of the first to
agree to performance bonuses in his contract, making an additional 20% of his salary dependent on his
performance. Previously that 20% was routinely given to the player regardless of performance.
Another topic that can generate good class discussion is monitoring. Under some circumstances,
employees don’t need to be monitored. If incentives are compatible, then the employees’ maximization
problem is structured such that by maximizing their own utility, profits are maximized for the principal. In
cases where this is not possible and shirking may occur, monitoring is required. An interesting topic to
discuss here is the efficiency wage debate, as this provides a link to macroeconomics. Logic dictates that
while at an individual level, efficiency wages should work, at a macroeconomic level, they should be
inflationary. Especially in times of very low unemployment (such as 1996–2000), if firms are paying
workers some level above the reservation wage, wage inflation should occur. Unfortunately, empirical
confirmation of this effect is far from certain.
In section 20.4, the focus moves from incentive compatibility for the agent to credibility of the principal.
An example that students will likely be familiar with are rental bonds. In many places, these bonds are
held by an independent authority to deal with any disputes at the end of a tenancy.
Overall, this chapter should prove very interesting for students, whether they are preparing to enter the job
market for the first time or have a great deal of experience. A good exercise might be to look at how
contracts vary across professions and determine whether they vary due to informational asymmetries or
incentive compatibility issues.
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
Microeconomics 9th Global
Edition By Jeffrey Perloff
(All Chapters 1-20, 100%
Original Verified, A+ Grade)
All Chapters Arranged Reverse:
20-1
This is The Original Instructor
Manual For 9th Global Edition,
All other Files in The Market are
Fake/Old/Wrong Edition.
,Chapter 20
Contracts and Moral Hazards
Chapter Outline
Challenge: Clawing Back Bonuses
20.1 The Principal-Agent Problem
Efficiency
Symmetric Information
Asymmetric Information
Solved Problem 20.1
Application: Honest Cabbie?
20.2 Using Contracts to Reduce Moral Hazard
Fixed-Fee Contracts
Contingent Contracts
State-Contingent Contracts
Application: Health Insurance and Moral Hazard
Solved Problem 20.2
Profit-Sharing Contracts
Solved Problem 20.3
Application: Sing for Your Supper
Bonuses and Options
Piece Rates
Commissions
Solved Problem 20.4
Choosing the Best Contract
20.3 Monitoring to Reduce Moral Hazard
Bonding
Bonding to Prevent Shirking
Trade-Off Between Bonds and Monitoring
Solved Problem 20.5
Problems with Bonding
Application: Capping Oil and Gas Bankruptcies
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
,347 Perloff • Microeconomics, Ninth Edition, Global Edition
Deferred Payments
Efficiency Wages
How Efficiency Wages Act like Bonds
Efficiency Wages and Unemployment
Application: Wal-Mart’s Efficiency Wages
Monitoring Outcomes
20.4 Checks on Principals
Application: Layoffs Versus Pay Cuts
20.5 Contract Choice
Challenge Solution: Clawing Back Bonuses
ONLINE: Thinking Critically About a Current Event: Splitting Ill-Gotten Gains
Teaching Tips
Chapter 20 continues the discussion started in Chapter 19 on transaction costs. Although it is not necessary
to cover all of Chapter 19 before Chapter 20, it will be helpful if the class is familiar with at least the
introductory portion of Chapter 19. Whereas Chapter 19 concentrated on informational asymmetries with
respect to a participant’s true nature at the time of agreement, Chapter 20 focuses on how incentives
influence behavior once a contract has been agreed upon.
However, the material is not difficult and need not be saved for the end of the semester if you are
interested in including it earlier. For example, one logical place to discuss principal-agent problems is
while covering the factor markets (Chapter 15). By doing so, you can contrast labor markets at the
aggregate level with labor contracts at the individual level.
One of the keystones of the material in this chapter is incentive compatibility. You might suggest to the
class that whenever they are evaluating an individual-level transaction, one of the prerequisites to sound
analysis is to check the incentives of the buyer and the seller. The application on selfless or selfish doctors
is a good way to motivate the discussion. This application should lead the students to think of experiences
they’ve had or heard of in unnecessary dental work or medical tests. By beginning the discussion in this
way, you should be able to lead the class directly to the importance of information and the opportunity for
moral hazard problems to arise when information is asymmetric.
The optimal contract type depends on the level of uncertainty and symmetry of information between buyer
and seller. Possible arrangements include piece rates, fixed fees, hourly rates, and contingent fees. You
might present the class with a number of transactions and ask them to decide what the best type of contract
is. They may find that in many cases, the seller would prefer one type of contract and the buyer another,
and a compromise between efficiency and risk bearing must be sought.
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
, Chapter 20 Contracts and Moral Hazards 348
The text includes an example of Amy and her employer, Paul, and the optimal employment contract.
Another example is a professional athlete and a team owner. The athletes would like for the contract to be
guaranteed, so that no matter what the performance level is, he or she receives payment. Employers
(teams) would prefer to pay employees based on performance. The advantage of sports examples is that
there is a steady stream of stories throughout the year of player negotiations that have reached stalemates
over contract structure.
An extreme example is professional baseball, in which top draft picks demand large contracts (typically in
excess of $8 million) with a good portion guaranteed as a “signing bonus.” These demands come despite
the fact that the drafted players have never played at the major league level. Because of the uncertainty
involved (many top drafted players never succeed at the professional level in baseball), some teams have
been very reluctant to meet players’ demands. In 2009, NBA rookie Ty Lawson was one of the first to
agree to performance bonuses in his contract, making an additional 20% of his salary dependent on his
performance. Previously that 20% was routinely given to the player regardless of performance.
Another topic that can generate good class discussion is monitoring. Under some circumstances,
employees don’t need to be monitored. If incentives are compatible, then the employees’ maximization
problem is structured such that by maximizing their own utility, profits are maximized for the principal. In
cases where this is not possible and shirking may occur, monitoring is required. An interesting topic to
discuss here is the efficiency wage debate, as this provides a link to macroeconomics. Logic dictates that
while at an individual level, efficiency wages should work, at a macroeconomic level, they should be
inflationary. Especially in times of very low unemployment (such as 1996–2000), if firms are paying
workers some level above the reservation wage, wage inflation should occur. Unfortunately, empirical
confirmation of this effect is far from certain.
In section 20.4, the focus moves from incentive compatibility for the agent to credibility of the principal.
An example that students will likely be familiar with are rental bonds. In many places, these bonds are
held by an independent authority to deal with any disputes at the end of a tenancy.
Overall, this chapter should prove very interesting for students, whether they are preparing to enter the job
market for the first time or have a great deal of experience. A good exercise might be to look at how
contracts vary across professions and determine whether they vary due to informational asymmetries or
incentive compatibility issues.
Copyright © 2024 Pearson Education Ltd. All Rights Reserved.
