Economics 174

Problem Set 1 -- Due Wednesday, April 16 These questions are due at the beginning of class, April 16. Sample solutions will be available on the web shortly thereafter.

These are designed to be answered in a paragraph or two on the average. Write as much as you need toward providing a clear and full response to the question, but no more.

If you want more practice with the material, additional problem set questions (from when I previously taught this class) are on the web. Solutions will be available to these questions as well after April 16.

Good luck!

1. Does value maximization imply efficiency? Why or why not?

Value maximization does imply efficiency, even when there are wealth effects. Suppose one is comparing a value-maximizing arrangement with one that is not. Because the "size of the pie" is smaller in the latter, one could not make everyone at least as

well off in the second arrangement as in the first. Therefore, the first arrangement must be efficient.

If there are wealth effects, there may be non-value-maximizing arrangements that are efficient as well. The reason why is that if we allow wealth effects, then we allow peoples' valuation of goods to depend on their wealth. In such circumstances, situations

can arise in which one could not pay off individuals for agreeing to move from a non-value-maximizing arrangement to a

value-maximizing one.

[Consider the case in class where the value-maximizing arrangement involved me teaching USC's offensive linemen.]

2. Why are contracts incomplete? Explain why contractual incompleteness can create a situation where individuals make decisions which are not value-maximizing (with respect to the organization). Describe an activity or institutional feature which organizations adopt in response to individuals' incentives to exploit such situations and gain privately at the expense of others within the organization.

Contracts are incomplete because a) in some cases parties cannot conceive of or verify all possible states of the world (and hence cannot specify actions and transfers in such states, and b) they are costly to construct even if parties could conceive of all possible states.

When some parties in the contract cannot verify the state of the world (but others can), the informed parties can behave "opportunistically" in a way anticipated by all parties. This was the case in the adverse selection and moral hazard problems we talked about (and will talk about more) in class. When a state of the world not covered by the contract is reached, individuals may act "opportunistically" in a way unanticipated by the parties.

3. The First Welfare Theorem maintains that every competitive equilibrium is efficient. Under the assumptions of the FWT, pursuit of private goals by individual firms and consumers leads to socially efficient outcomes. In the FWT, all coordination is mediated by market prices.

Might alternative means of coordination be efficient if the assumptions of the FWT hold? Might they make everyone better off than under price-based coordination?

Yes, alternative means may be efficient. The FWT states only that using price-based coordination is efficient, but does not say anything about the efficiency of alternatives. (There may be multiple efficient arrangements.) However, the efficiency of the price mechanism under the FWT implies that alternative means of coordination could not make everybody better off. At best, they would make some better off and some worse off.

"No missing markets" and "all firms and consumers are price takers" are necessary conditions for the FWT to hold. Why might price-based coordination not lead to efficient outcomes if these conditions do not hold?

These lead to price distortions -- prices of resources are no longer equal to their social value. As a result, decisions made by firms and consumers toward maximizing profit or utility may be inefficient.

For example, if the supplier of screws is a monopolist (and sets prices above competitive levels), this will induce demanders of screws to use a less efficient production process which uses fewer screws and more of something else. One could produce just as much at lower (social) cost with the number of screws that would have been used, were prices at competitive levels. The higher price in the monopolistic case directed individuals to use inputs in a privately optimal but socially inefficient way.

Might alternative means of coordination be efficient under when these assumptions are relaxed? Might such means make everyone better off than under price-based coordination?

If there are missing markets or firms/consumers are not price takers, private decisions will now not automatically account for resources' social value. There then may be an alternative institution in which private decisions do so, and which hence could make everyone better off than using prices alone.

This is a very hard question - - harder than you would get on an examination. The point is that if the assumptions of the FWT do not hold, prices cease to inform consumers and firms of resources' opportunity costs. Prices alone do not necessarily direct private decisions toward efficiency.

4. In our discussion of Coase's "The Nature of the Firm" in class, we considered the following situation:

Suppose you hire another individual to prepare your taxes. This individual does not have perfect information about your finances, nor can you perfectly anticipate what information he/she needs and supply it beforehand. Therefore, after you agree initially to the terms of trade with your tax consultant, there is the need for further coordination.

Ignore legal liability issues.

According to Coase, what characterizes firms?

The absence of the price mechanism.

In your judgement (and intellgent disagreement with your professor is encouraged), would Coase consider transactions between you and your tax consultant transactions within a firm? If the answer is "it depends," explain what it depends on and why. Justify your position in a paragraph or two.

This is a gray area. Assume that "you" are an entrepreneur. Hiring the tax consultant in the first place is a transaction between firms, as it is mediated by prices. If you have to coordinate his activities further, then things become unclear. This sounds like coordination by fiat -- much like an employer/employee relationship. So Coase might characterize these as "within a firm."

Coase admits that this is a point to which his theory does not speak very well. See p. 93-4.

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?

Assume that we are considering the welfare (profits) of the two firms, but not each individual at each firm. Then adoption is more efficient if it is part of an arrangement in which both firms are at least as well off, and one is better off, than in the existing 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?

No, it does not mean that it is inefficient, because the manufacturer may be able to make a side payment to the supplier (subsidize adoption) such that both parties are better off than with the existing system.

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?

By the Coase theorem, no wealth effects and zero bargaining costs.

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?

One reason is that, absent side payments, many suppliers' (especially small ones) costs of adopting EDI system outweigh their benefits. In such cases, auto makers have to subsidize adoption through side payments. Negotiating over the size of these side payments is costly. The problem is worsened because suppliers often have private information about their costs and benefits of adopting the new system, and have an incentive to exaggerate their costs to obtain a greater subsidy from Ford.

These bargaining costs may inhibit the adoption of technologies that would increase the productive efficiency of auto makers and their suppliers.