Changes

3. The Board of Directors does not approve of Carol's wasteful money burning scheme. Fortunately, Carol knows that her employees all have CARA preferences with an identical risk-aversion parameter, <math>\rho</math>. She proposes a clever new scheme to get all the Yahoos to work. What is it?

Consider a buyer-seller transaction in which the buyer makes a relationship specific investment x in period 1. This investment costs the buyer <math>x^2</math>, and it only pays off if the buyer is supplied with a “widget” by the seller in period 2. The return from investment (assuming the widget is supplied) is x + v, where v is a random variable uniformly distributed on <math>[– h,h]</math>. Assume that <math>h\in[0.25,0.5]</math>. Neither x nor v is observed by the seller, and the buyer only learns v in period 2 so that investment x is made prior to learning v. The seller's cost of producing the widget is zero.

(c) Compare your solution in (b) to the first-best level obtained in part (a). How does the buyer’s investment vary with the amount of noise, h?

In many political and business settings, control over the agenda of policy changes is a