Economics 174

Problem Set 1 -- Due Friday, October 11

1. One feature of many labor contracts is work rules. Work rules restrict managers with respect to how to organize production. For example, work rules in a labor contract between railroad engineers and railroads may limit the number of hours per day or week individual engineers can work. One implication of such a provision would be that the engineer could not work additional hours, even in individual cases where both the railroad and the engineer (perhaps because they are being paid above their normal wage for the extra hours) would be better off if they could do so.

Assume that we are considering only the interests of railroads' shareholders and employees (white and blue collar workers). Assuming no wealth effects or transaction costs, is a limitation of engineers' hours likely to be part of an efficient institutional structure? Why or why not?

Sometimes laws, rather than negotiated work rules, put limits on employees' hours. Is there an efficiency explanation for such laws with respect to railroad engineers?

2. Economic consulting firms often have two tiers of senior economists: for simplicity, I will refer to them as project leaders and staff economists. Project leaders recruit clients (usually law firms, in this case) and are in charge of any case for which they are hired. They generally cultivate clients and complete their work with little supervision or direction from upper level management. Clients are billed by the firm. The project leader receives a relatively high percentage of the revenues the firm receives from the clients they bring in. Their billing rate is often well over $100 per hour, sometimes more. Staff economists work on cases under the direction of project leaders; their billing rate is substantially lower than project leaders.

Using the criteria proposed by Coase, should economic consulting firms be viewed as single firms, or separate firms? Using this criteria, do upper-level managers, project leaders, and staff economists all work for the same firm? Explain.

3. According to Alchian and Demsetz, why are managers residual claimants rather than workers? Are managers generally residual claimants in real life? If so, in what types of firms? Where this is not the case, what new incentive problem arises?

4. Define moral hazard. Why do incomplete contracts often create situations of moral hazard? Provide an example of an institution or organizational feature that arises in response to moral hazard (that is, something that we would do not observe in situations where there are not moral hazard problems).

5. One of the trends in business during the past ten years or so is the increasing use of electronic data interchange, or EDI. In electronic data interchange, firms use computer networks or dial up connections to exchange information such as invoices, orders, delivery confirmation. These replace previous processes in which such information was exchanged using phone, fax, or even mail-based systems. One advantage is that they permit the timely exchange of data. Another is that they can be linked to firms' internal computer systems so that individuals do not have to rekey information when it comes in. A drawback is that they often require firms to purchase considerable amounts of new hardware or software, and they can require them to make costly changes to their existing business practices to take full advantage of the new capabilities.

Suppose we are considering whether a specific supplier and manufacturer will adopt this new technology.

What determines whether doing so is efficient relative to their current fax-based system?

Suppose that the manufacturer anticipates that the new system will generate production improvements that will greatly outweigh the cost savings, but that the supplier anticipates that the new system will not "pay for itself." Does this mean that adoption is inefficient? Why or why not?

Assume that adoption is efficient relative to current systems. Under what set of assumptions is adoption guaranteed to take place, even if the investment does not "pay for itself" for one of the firms?

Automobile makers (Ford, GM, Chrysler, et al) have been struggling for the past five to ten years to get their outside suppliers to move to EDI-based systems. Using the ideas presented in class, why would you expect that they would have such a difficult time doing so, assuming that EDI is efficient relative to other systems?