Problem Set 1 -- Due Wednesday, April 17
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 much be efficient.
If there are wealth effects, there may be non-value-maximizing arrangements that are efficient. 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.
[Suppose someone's utility derived from consuming certain things ("ice cream") declines with their wealth, and suppose we start off at a non-value-maximizing arrangement. It may be impossible to compensate this individual enough to make him or her agree to a value-maximizing arrangement, because giving them more wealth may make them worse off because they would value the ice cream they consume much, much less.]
2. Movie theater chains and distributors are often under the same firm name (under the legal definition). For example, United Artists both distributes movies and owns a large theatre chain. Top executives have control rights with respect to both divisions. For example, the CEO at UA probably has the right to hire and fire staff within both divisions. However, when movies come out, federal law requires them to be offered to theatres on a non-discriminatory basis. Theatres within United Artists' chain must bid against local competitors for the right to show movies distributed by United Aritsts. According to the criteria proposed by Coase, are UA's distribution division and UA's theatre chain part of the same firm, or are they different firms?
There is no single right answer to this. Coase would say that the price mechanism does not coordinate relationships between UA's CEO and the head of UA's theater chain. UA's CEO is able to direct the activity of the theater chain head by fiat. However, the price mechanism does serve to coordinate the use of UA theater chain's inputs -- the movies themselves. Theaters must outbid competitors for the use of this input.
This kind of ambiguity often arises when firms use internal transfer prices to coordinate their activities. With respect to Coase's definition of the boundaries of the firm, these fall into a gray area.
3. In Alchain and Demsetz, a "metering problem" gives rise to a particular set of contractual arrangements which they claim shares aspects with the neoclassical firm. Do these contractual arrangements eliminate shirking altogether? Is production likely to be greater, the same, or less than in the case where individuals do not shirk at all? Given that this "metering problem" causes individuals to invent novel and potentially sophisticated means of mitigating its effects, why is team production ever chosen over individual production? (After all, in individual production, one can measure individuals' productivity and pay them accordingly -- so they bear the cost of their own shirking.)
Monitoring generally does not eliminate shirking altogether, though it may reduce it. Production is likely to be greater, because individuals' efforts are likely to be greater. Team production is often chosen over individual production when individuals' marginal product is greater when working within a team than alone.
4. Define bounded rationality. Why does bounded rationality lead to incomplete contracts?
Bounded rationality, according to Milgrom and Roberts, describes the limitations of human mental abilities that prevent people from foreseeing all possible contingencies and calculating their optimal behavior. This leads to incomplete contracts because complete contracts require parties to specify rights, actions, and transfers in all possible contingencies.
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.