Economics 174

Problem Set 2 -- Due Monday, May 3

These questions are due at the beginning of class, May 3.  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 May 3.

Good luck!

1.    Define "greenmail."  Discuss the role greenmail plays in the market for corporate control.  Be sure to discuss whether it is likely efficiency-enhancing or not, and why.

Greenmail refers to a class of takeover defenses in which managers use the resources of their own firm to  pay off  either those making outside offers or blocks of their own shareholders.  Greenmail is generally considered to hinder the operation of the market for corporate control.  If takeover attempts are symptoms that target firms are organized inefficiently, and greenmail prevents firms from reorganized in a more efficient way, greenmail would not be efficiency-enhancing.

2 . In Jensen and Meckling's model, managers who own less than 100% of the firm are unable to guarantee shareholders that they will make the same decisions they would if they were sole owners. Why is this costly? What individual or group of individuals bear these costs? What assumption concerning individuals' foresight drives this result?

Managers will make decisions toward maximizing their own utility. If they are full owners, they reap the full benefits and bear the full costs of these decisions. Therefore, these      decisions will be value maximizing. These decisions may be different, and therefore not value-maximizing, when they do not bear the full costs of the decisions they make. Not being able to guarantee shareholders that they will make the decisions they would if they were sole owners means that some decisions will not be value-maximizing. Thus, this is costly.

The entrepreneurs/managers themselves bear these costs, because shareholders will only be willing to pay the value of the equity under the new ownership structure. This assumes that shareholders can see through entrepreneurs/managers' private incentives and understand how they will behave under the new ownership structure.

3.    You are the owner of a small trucking firm in LA.  You employ several similarly risk averse drivers who value both income and leisure.  The firm's output, and thus profit, is a function of your drivers' effort -- high effort levels mean that your firm is able to serve more customers because your trucks are on the road and moving more of the time.  Effort, however, is costly to drivers.

Assume that individual truck drivers' output is observable (the number of "hauls" he makes, how long they are, etc.) to you.  Output is a function of driver effort and of factors outside of his control, such as traffic.  Assume that you can directly observe only output and not effort.

Your drivers run two types of routes.  One goes back and forth between West LA and Bakersfield.  On the average, there is very little traffic, and not much difference in the traffic from day to day.  The other goes back and forth between West LA and Pomona.  Because it goes through Downtown LA, this route tends to have a lot of traffic, and a lot of variablility in traffic.

You are trying to design optimal compensation contracts for drivers on these different routes.  Compensation consists of a fixed wage plus a per-mile rate.  Assume that the market for truck drivers is perfectly competitive -- truck drivers' utility from working for you is the same as that in their next best opportunity.

The fact that drivers (but not firms) are risk averse and that only one dimension of effort matters to the firm means that the simple model developed in class applies.  Differences in traffic patterns mean that a) there is more variance in factors outside of drivers' control when they are going to and from Pomona than to and from Bakersfield, and b) drivers going to and from Pomona are less able to respond to incentives because they are more prone to be stuck in traffic.  Both of these imply that you should pay the drivers going to and from Bakersfield stronger performance incentives (higher per mile rates) than drivers going to and from Pomona.  In the framework in class, the first refers to differences in V and the second refers to differences in C"(e).  (Don't worry if you did not pick up on both -- one or the other is sufficient.)

Both types of drivers will be no better off than their next best opportunity by assumption.  The Bakersfield-bound drivers are earning higher commissions on the average.  It is therefore likely that they will be paid lower fixed wages.  (This holds as long as drivers are not very risk averse.  One needs to make stronger assumptions about their degree of risk aversion for this to be strictly true from the theory.)  With respect to fixed wages, either "Bakersfield is lower" or "ambiguous" are acceptable answers.

See above.

You hook yourself up to the internet.  On its website, Caltrans has a page which offers up to date traffic reports on all major Southern California highways.  This provides a good, but imperfect, signal of the conditions your drivers face.

Using the device means that you can better measure factors outside of your drivers' control.  This lowers V in the framework.  If V is lower, it is optimal to pay stronger performance incentives.  So per mile rates will go up and fixed wages will go down.  The change will probably be greatest for the Pomona drivers -- where there was the most variability to begin with.  (Having the web say "there is no traffic going to Bakersfield" most of the time does not improve your information because it is something you already knew.)

4. Firms often find it difficult to monitor their workers' use of telephones. For example, when I worked for the Council of Economic Advisers in Washington, there was no monitoring whatsoever. Furthermore, there was no accounting system to track the location, length, and cost of long distance telephone calls. As a result, my coworkers and I frequently made lengthy long distance phone calls from office phones. There were even instances where individuals came into work on the weekends for the sole purpose of making long distance calls.


The principal(s) could be taxpayers, the Federal Government, the CEA, or the head of the CEA, etc., depending on how you look at it. The agents are the workers. Their objectives differ because everything that enters positively into workers' utility does not contribute to bureaucratic output, and things that contribute to output enter negatively into workers' utility. The incentive conflict arises because private telephone calls are contribute to positively workers' utility but negatively to the value of whatever the CEA produces. A moral hazard problem arises because prinicpals cannot costlessly observe or monitor agents' phone usage.

Suppose the press got wind of this, and in the ensuing media uproar, the Federal Government announced that it was going to implement a new system to monitor telephone usage. At the end of each day, individuals would receive a print-out of describing each telephone call they made. Unless they could provide evidence that a call was for legitimate government business, the cost of the call would be deducted from their (after tax) pay.


Closer monitoring would likely reduce telephone usage, because making a private call is now more costly in some way to agents (even if it is just in having to figure out how to explain away phone calls). Agency costs are not necessarily lower, because agency costs include the costs of monitoring, which are undoubtedly higher in this new situation.