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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?
====Question B2: Relationship Specific Investments====
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.
Assume that no long-term contracts are possible and that the seller makes a take-it-or- leave-it offer to the buyer in period 2 (after the buyer has learned v). This offer is based on the seller's conjecture about the buyer's choice of x which will be correct in equilibrium (rational expectations).
(a) Compute the socially optimal investment decisions.
(b) Compute the buyer's equilibrium choice of investment. (Hint: observe that since the seller does not observe the buyer’s investment when making an offer, you can treat the buyer’s choice of investment and the seller’s choice of an offer as a simultaneous-move game.)
(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?
===Question C1: Agenda Control and Status Quo===
