Say that a financial intermediary is hired to make a transaction \"go forward\".
ID: 1219957 • Letter: S
Question
Say that a financial intermediary is hired to make a transaction "go forward". The intermediary can do a good job that costs the intermediary $5,000, or do a bad job that costs the intermediary zero. If the intermediary does a good job the transaction will go forward. If the intermediary does a bad job the transaction will go forward with probability 0.8, and will fail with probability 0.2. The customer can't observe the intermediary's job choice and simply pays the intermediary $X if the transaction goes forward and pays $0 if it fails. What is the minimum X the customer must pay in order to persuade the intermediary to do a good job?
Explanation / Answer
Intermediary hired for "go forward".
Two options with intermediary
1. Do good job and transaction forward with probability =1
2. Do bad job and Transaction forward with probability = 0.8
Consumer has to pay the intermediary such that it cannot differentiate between the good and the bad. Or if the payoffs from Good as well as bad are equal enough, and if it could meet the cost of intermediary then we can assure that there will be "go forward case only'
Thus consumer must pay = Cost of Good Job to Intermediary / The probability of the failure = $5000/0.2 = $25,000