8. Michael wants to rent out a flat from Susan. Michael has a big passion for art and enjoys drawing, so much that he often draws on any surface he can find, including walls.
Michael’s receives £400 in utility from being able to draw on the walls of the flat, whereas Susan would like the walls to remain clean.
If Michael draws on the walls, it will cost Susan £700 to have the walls repainted. Thus, Susan is considering charging Michael a damage deposit of £700. (10 marks)

a) Explain why this situation could be considered a principal-agent problem. (5 marks)

 

b) Draw the extensive form of this principal-agent problem and use backward induction to solve for the Nash Equilibrium. (5 marks)