Economics 174

Problem Set 3 -- Due Monday, May 24

1.. In order to attract candidates from liberal arts universities without formal accounting majors, the big six accounting firms run a special program in conjunction with New York University's Stern School of Business. Liberal arts majors who are hired must attend school during summers and at night for two years. The employee must pay for this schooling; assume that it costs $5,000. After they finish their courses, employees take the CPA exam. During they time they are going to school (and working), employees are paid $35,000/year.

Classes are composed entirely of new employees of big six accounting firms. Because they are in the midst of receiving exactly the same training, it is common for new employees to switch firms during their first two years. Effectively, each of these trainees always has the opportunity to switch to a different big six accounting firm and be paid $35,000/year.

During March of my senior year at school, my two most attractive offers were from a big six accounting firm and an economics consulting firm. The big six accounting firm's offer is described above. The economic consulting firm's offer was $25,000/year. Assume that the consulting firm has a policy of not hiring anyone who has ever worked at an accounting firm (it is extremely costly to retrain accountants to do good economic analysis). My next best opportunity was earning $22,000/year at a health care management firm in New York. This offer would stay open for the foreseeable future, and it would remain better than any other opportunity.

Assume that I care only about my net income. I therefore choose to work at the accounting firm. How much, if anything, of my starting salary can be considered an economic rent? How much, if anything, of my starting salary can be considered a quasi-rent? Do there exist appropriable specialized quasi-rents? If so, how much? If not, why not? Is there a hold-up problem?

Rents are payments in excess of what it would have taken to make me an accountant rather than an economic consultant. According to the assumptions above, I would have been indifferent between the two jobs if the accounting firm offered $30,000 ($35,000-$5,000) in salary. Therefore, $5,000 of my salary should be considered rents. Quasi-rents are payment in excess of the amount it would take to keep me an accountant. My next best oppportunity (after I accepted the accounting job) was earning $22,000. Therefore, quasi-rents equal $8,000. None of these are appropriable, because if the accounting firm I was at tried to appropriate even one dollar of this, I would simply switch to another accounting firm. There is no hold up problem.

Suppose the accounting firms get tired of turnover among their new employees, and announce a policy of not hiring trainees away from each other. Does this change the answers to the above questions? Explain.

Yes. The quasi-rents are now entirely appropriable. There is now a potential hold up problem. The accounting firm I worked for might be able to force me to renegotiate my salary down to $27,000/yr. If I saw that this was going to be the case, I would either a) devote resources toward keeping this from happening, or b) not take the job at the accounting firm.

2. Firms use various types of trailers when hauling goods by truck. Two examples are "basic vans" and "grain bodies." Basic vans are used to haul general freight: goods which are packaged in boxes and which are not temperature-sensitive. (These are the familiar box-like trailers you see on the road.) Grain bodies are trailers which have no top, but have sides which are reinforced by layers of steel that can withstand large amounts of pressure from inside.

To what degree are basic vans specific to uses? To users?

Basic vans are not very specific to uses -- one can use them to haul many different commodities. They are specific to users to the extent that it is costly to find and transport the trailer to a new user. Such costs are not very large in circumstances where there are many shippers who can potentially use basic vans. (They would be larger -- and basic vans would be more specific to users -- say, in the middle of the desert.)

To what degree are grain bodies specific to uses? To users?

Grain bodies are specific to uses -- they lose a lot of their value if they are not used to haul grain. Like basic vans, they are specific to users to the extent that it is costly to find and transport the trailer to the next best user. In circumstances where there are many shippers which haul grain by truck, they are not very specific to users. In circumstances where there are few such shippers (or a low density of such shippers), they tend to be relatively specific to users.

Hubbard (1998) finds that nationwide, about 35% of hauls which use basic vans are completed by private fleets -- circumstances where manufacturers, distributors, retailers, etc., haul their own goods. The rest are completed by for-hire trucking firms. In contrast, 75% of hauls which use grain bodies are completed by private fleets; only 25% are completed by for-hire fleets.

Interpret these facts in light of one or more of the theories presented in class and/or in the readings. You may either do so by outlining a theory which explains the facts, or by explaining why the facts are inconsistent with the theories we have encountered.

These figures imply that competitive contracting is generally used when hauls require basic vans. Vertical integration is more the rule when hauls require grain bodies.

This is quite consistent with Klein, Crawford, and Alchian. Grain bodies are more specific to users. Lower density of users implies that it is more costly to find and transport the trailer to alternative users than for basic vans. Under competitive contracting, this implies that appropriable quasi-rents would tend to be greater for grain bodies than for basic vans. Vertical integration would hence tend to be efficient relative to competitive contracting more frequently for hauls using grain bodies than for those using basic vans.

[I operate a trucking company. Someone phones me up. We agree on a price. I drive the tractor-trailer to your door. Once I do so, it is costly for me to find and serve other shippers -- the more distant the alternative shipper, the more costly it is. If the alternative shipper is right next door and you try to renegotiate the price, I simply serve the shipper next door. If the alternative shipper is halfway across the state, you may well be successful in your renegotiation. The hold-up problem appears in the latter case but not the former, because the proximity of the alternative user affects the extent to which quasi-rents are appropriable. Alternative users tend to be more nearby for trailers which can be used to haul many commodities.]

Further research indicates that 55% of hauls which use grain bodies in Iowa are completed by for-hire trucking firms, but 5% of hauls which use grain bodies in Oregon do.

Is this a surprise, in light of what we have discussed in class? Why or why not?

Much grain is grown in the state of Iowa. Little grain is grown in Oregon. Alternative users would be easy to find and geographically nearby with respect to grain body trailers in Iowa. They would be harder to find and geographically more distant in Oregon. Appropriable quasi-rents would be greater in Oregon than in Iowa. This implies that competitive contracting would tend to be efficient more frequently in Iowa, but not Oregon, with respect to hauls using grain bodies.

3. When one firm purchases another, it often justifies the purchase by claiming that there exist "synergies" -- that somehow the value of the merged firm is higher than the sum of the values of the two firm given separate ownership.

What happens when firms merge, according to Hart? That is, what is the difference between a merger and contracting?

According to Hart, when firms merge, one moves from an arrangement in which separate entities own physical assets to one in which a single entity owns all physical assets. The owner here is defined as the entity with residual control rights over the asset -- the right to make decisions about assets' use in circumstances where contracts are silent.

According to Hart, the difference between a merger and contracting is contracting does not transfer residual control rights. Separate entities own the different physical assets.

According to Hart's theory, what must be true for a merger to be value-increasing? (It may be easier to start by stating the conditions under which a merger cannot be value-increasing.)

Physical assets must be complementary -- not independent. That is, their value when used with each other must be greater than their value when used in conjunction with other assets.

The reason this is true is the following: start with a situation where separate managers own two different physical assets. These managers have good incentives to make non-contractible investments which are complementary to their assets. Each manager could threaten to withdraw their asset in an attempt to get more of the pie, but these threats would not have much teeth. If the assets are independent, no value is lost if the managers do not trade with each other. Therefore, neither manager fears appropriation of their non-contractible investments -- so they have strong incentives to invest.

If one manager owns both physical assets, this is likely worse for the following reason. Owning both assets does not improve the manager's investment incentives -- he or she had good incentives even owning only one of the assets. Owning neither asset weakens a manager's incentives, however. So a merger would weaken one manager's incentives without improving the others. This is why separate ownership is efficient when physical assets are independent.

4. Using efficiency wage theory, explain why the salary of a 60-year old executives might be higher than the salary of 45-year-old executives who are equally talented and knowledgeable and whose outside opportunities are exactly the same.

Does efficiency wage theory provide a coherent explanation for why compensation generally increases with age for salaried workers? Why or why not?

60-year olds are close to retirement than 45-year olds. "N" -- the number of periods to go in the relationship -- is lower. Therefore, in order to satisfy the executive's "no shirking constraint," one would have to pay the 60-year-old a wage such that the differential between it and his/her next best opportunity is larger.

By a similar logic, efficiency wage theory provides a coherent explanation for why compensation generally increases with age for salaried workers. One has to pay them more and more to satisfy their no shirking constraint.

This is not the only possible theory for the relationship between wages and age. But it is a theory that is consistent with the facts.