Final Examination -- Fall 1996

There are eight questions on this examination. The exam lasts 180 minutes; there are 180 points. Plan your time accordingly. The first six questions are worth 20 points apiece; the final two are worth 30 points apiece.

You are allowed to work overtime at a price of two points per minute. This provision will be strictly enforced, but you are welcome to work late if you feel that the benefits exceed the costs.

Read each question and think before you start writing. You will be graded not just on your familiarity with the concepts in class, but also your ability to express the concepts clearly and precisely. Be sure to notice exactly what the question asks. Underline or otherwise indicate your most important points.

Good luck!

1. In Nelson and Winter's theory of the firm, what motivates individuals to act in a value-maximizing way? That is, what deters them from shirking? In general, is this an incentive-based theory of the firm? (Is the theory primarily about how firms provide self-interested individuals incentives?) Why or why not?

2. You work for a record company. Your company has reached an agreement with a band to provide a record in each of the next two years. It is your responsibility to negotiate the terms of the contract. Contracts generally include a fixed payment per record (an advance), plus a payment based on record sales. Assume that your company is risk neutral and the band is risk averse.

Record sales are a function of the band's effort (both how hard they work when creating the record, how much they tour, the quality of their live performances, etc.) and of factors outside of their control (consumers' tastes for their music, fads, etc.). Assume that record sales are directly observable; effort, consumers' tastes, and the effect of fads are not.

Suppose that the effect of consumers' tastes on record sales is correlated from period to period. Once the first record's sales are realized, is it in your company's and the band's interest to renegotiate the terms of the agreement you originally reached with respect to the second record? Why or why not?

Suppose the effect of factors outside the band's control is not correlated from period to period. Does this change your answer to the above? Why or why not?

3. Define innovational complementarity. Describe an instance of innovational complementarity encountered in class. Explain thoroughly why this is an example of innovational complementarities.

4. Under what circumstances would market prices alone coordinate economic activities efficiently? Under such circumstances, is there an efficiency explanation for the emergence of firms, organizations, or other economic institutions?

5. In some circumstances, it is desirable for individuals or firms to undertake relationship-specific investments. What incentive problems arise in these circumstances? What are the efficiency implications of these incentive problems? What organizational or contractual features can be interpreted as a response to these incentive problems?

6. Many firms pay some of their workers a function of their output, particularly when only one dimension of workers' production (for example, the quantity they produce) matters. What are the benefits and drawbacks of paying workers in this way?

7. In lecture, we derived the attributes of the optimal single-period linear compensation contract between a single risk neutral principal and a single risk averse agent. In that model, in all but the most extreme cases (for example, when the agent is infinitely risk averse), the optimal contract was to compensate the agent at least in part as a function of the output he or she produces. Most workers' compensation, however, is not based explicitly on an output measure. That is, they are not paid strong output-based performance incentives. Briefly explain why not basing workers' compensation explicitly on measures of output might be optimal. (You get more points if you provide more than one reason.)

8. Please read the attached excerpts of a recent Fortune magazine article about Starbucks and answer the following questions.

How are managers of Starbucks outlets compensated? Are they residual claimants with respect to their outlets, like owners of Subway restaurants are?

How are non-manager employees of Starbucks outlets compensated? Are they paid explicit performance incentives? How does Starbucks elicit effort from its workers via compensation schemes?

Like McDonald's, Starbucks sends staff to training programs at central or regional offices. Unlike McDonald's Starbucks sends all employees to these programs. This is unusual. At most firms which operate chains of stores, managers train lower-level workers. How might Starbucks' decision to send all workers to formal training programs be related to other organizational features of the firm -- for example, how managers and workers are compensated?