Problem Set 3 -- Solutions
1. Define residual control rights. What inefficiencies arise from a misallocation of residual control rights?
Residual control rights are the rights to make any decisions regarding an asset's use that are not explicitly assigned to another party in a contract. From the model presented in class, a misallocation of residual control rights may lead to underinvestment in human capital that is specific to certain trading relationships.
2. Fast food franchisors sometimes own the land upon which their franchisees' restaurants are built, and lease the land to the franchisees. How would franchisees' work and investment incentives (for example, investments in their own human capital) differ if instead a third party such as a bank owned the land? How would they differ if instead the franchisee owned the land?
When the franchisor owns the land, it can deny the franchisee the ability to operate the restaurant at that location. Thermination is thus more costly than it otherwise would be. One would expect that this would increase the franchisee's incentive to abide by the terms of the franchising contract. This may mean that franchisors will have an incentive to appropriate the value of any franchisor- or location-specific human capital. If so, franchisees will be reluctant to make such investments. If franchisors are able to commit to not do so (perhaps because doing so would lower the price of franchises they wish to sell to others), this will not affect investment incentives.
When a third party owns the land, they have residual control rights over it. There may be circumstances where the lease is not renewed (a developer wants to build a shoping mall on it), but this would probably not have anything to do with whether the franchisee is abiding by company policy. So work incentives will probably not be affected much. But because the franchisee does not have residual control rights over the land (which is strictly complementary to his restaurant), he will probably underinvest in specific human capital as a result.
3. A general principle of organizational design is to design institutions which encourage value-creating activities and discourage rent-seeking. In class, we used this idea to explain why Stanford University goes to great pains to have faculty offices be exactly the same. What is the nature of rent-seeking in this case and why is it inefficient?
Rent seeking in this case was that faculty would devote resources toward gaining a higher fraction of value for themselves rather than increasing total value. Here, they lobby for larger offices rather than do research, teach, etc.
Suppose offices were not all the same, but were allocated by means of an auction. Would this system encourage activities that are privately optimal but are socially wasteful? If so, describe them, and describe how one might discourage such activities. If not, explain why not.
If the faculty were perfectly informed about the features of each office going in, the auction would not encourage such activities. They would simply bid for the offices. If the auction is designed properly, then the offices will be allocated efficiently. If they were not perfectly informed about each office's features, then faculty may have an incentive to devote resources toward information acquisition. This info acquisition would not improve the allocation of offices across faculty members (which would be efficient if each individual made uninformed bids), so it is inefficient. One might discourage information acquisition by publishing a detailed floor plan and description of each office and making it readily available.
4. When UCLA hires new assistant professors, the employment relationship is covered by renewable two-year contracts which contain no explicit performance incentives. (For example, we do not receive commissions on the basis of how many articles we publish, teaching ratings, etc.) At the end of the second and fourth year, each assistant professor receives a formal review of his or her teaching and research, and if evaluations are satisfactory, they may receive a raise. At the end of the sixth year, assistant professors come up for tenure. Those who do not receive tenure are not offered new contracts with UCLA; they must find another job, either at another school or outside academia. Those who do receive tenure are offered new contracts. Only about 15-20% of assistant professors receive tenure offers.
Assuming that UCLA wishes its assistant professors to work rather than shirk, how must it set salaries with respect to their next best opportunities? Will salaries change during the six year period? If so, how? If not, why not?
It must set salaries above their next best opportunity. Salaries will ahve to increase during the six-year period to deter shirking -- the number of periods "to go" is decreasing.
Suppose that UCLA can choose how much to monitor assistant professors' research and teaching, and that the marginal costs of monitoring are increasing with the level of monitoring. Will it behoove UCLA to monitor more toward the beginning or the end of the six year contract? Is this likely to differ across individual assistant professors? If so, how?
From the model presented in class, it behooves UCLA to monitor more at the end of the six year contract, where the number of years to go is low. The size of the efficiency wage and monitoring intensity were complements. This is likely to differ across individual assistant professors if they can anticipate their probability of getting tenure. One will have to monitor (and pay the highest efficiency wages to) those who believe they are unlikely to get it.
Not all courses offered at UCLA are offeret at many other universities. Would you recommend that untenured faculty teach these courses? Explain why or why not.
Untenured faculty should probably not teach these courses.
When preparing a course, the professor bears high sunk costs. When these are not specific to UCLA, these reaise his value not just to UCLA, but at other universities as well. The ability to teach Econ 101 is valuable everywhere. Professors have an incentive to make such investments because they cannot be appropriated by UCLA. When these are specific to UCLA, these raise his value to UCLA, but not other schools. The value can be appropriated by UCLA. They therefore have less an incentive to put effort into developing these courses.
It is true that if UCLA can require all assistant professors to put in high effort toward developing courses, this will enable UCLA to provide high work incentives because of the threat of termination. The situation would be similar to the Subway case -- where specific investmetns enabled the franchisor to provide the franchisee such incentives. But in fact, UCLA cannot easily verify the level of these specific investments. Because of the appropriability problem, assistant professors will tend to underinvest in developing courses which are specific to UCLA.