Final Exam -- Spring 1996

You have three hours to complete the following nine questions. You are allowed to work overtime, but at a price of 2 pts. per minute.

The total number of points on this exam is 180. You have 180 minutes. Allocate your time efficiently.

Questions 1-6 are worth 15 pts. apiece; questions 7 and 8 are worth 25 points apiece; question 9 is worth 40 points.

As always, a good strategy is to think about the question before you answer it. Clear articulation of your answers is valuable because it indicates how well you understand the underlying economic concepts.

Good luck!

1. What is the "winner's curse"? Describe how it affects the incentives of firms to undertake hostile takeovers. Describe how it affects the incentives of CEO's at firms which are potential targets.

2. Milgrom and Roberts explain movement between mass production and modern manufacturing with a theory based on complementarities among firms' activities. Describe two aspects of either mass production or modern manufacturing. Explain why they are complementary. According to Milgrom and Roberts, what economic forces have stimulated firms to switch from mass production to modern manufacturing. Why do these forces do so?

3. What are the agency costs of equity financing? Why do they arise? If equity financing entails such costs, why is equity financing used at all? Why don't entrepreneurs simply borrow money when they need outside financing?

4. Why were railroads among the first firms to develop sophisticated organizational structures? What function did middle managers play within these organizations?

5. What are the advantages of franchising rather than individual ownership of outlets? That is, why might franchising be more efficient than individual ownership? What agency problems appear in franchise arrangements that do not appear when outlets are individually owned? What features of franchising contracts mitigate these problems?

6. What are the conditions in which the Coase Theorem applies? Describe how each of these conditions may be violated.

7. You own a very small firm. Previously, you did everything yourself, but you now decide that you need to hire someone to help out -- for one period and only one period. One problem you have to solve is how to compensate him. Having taken Econ 174, you know that it is best to implement an efficient compensation scheme. The level of compensation is given: you are going to compensate him such that his CEQ is equal to that of his next best opportunity. The only issue is what form the compensation contract takes: that is, the extent to which you will use performance incentives.

Assume that you yourself will provide the same level of effort regardless of how you compensate your worker.

Under what circumstances will it be efficient to pay your new worker a fixed wage, with no variable component?

Under what circumstances will it be efficient to pay him a function of his output?

Under what circumstances would it be efficient to make him the residual claimant?

8. You own a firm which rents farm equipment to local farmers. The main piece of equipment you own is a tractor with a special attachment that digs and harvests vegetables that grow underground, such as potatoes and carrots. Presently, you rent this machine to one of the town's potato farmers, and you receive $1000/day. Other potato farmers in town would also be willing to pay you $1000/day; carrot farmers would be willing to pay you $900/day. Regardless of whether the machine is used to harvest potatoes or carrots, your average total cost for providing your service using this piece of equipment is $900/day.

One problem with this machine is that it is only able to harvest approximately 75% of the potatoes in any given field; it destroys the rest. You read a advertsement in a trade journal for a new attachment that will work on your machine. The price for this attachment (converting it into a rental-equivalent) is $100/day. Once welded onto the machine, this will allow you to harvest virtually all the potatoes in any given field. Surveying the market, you conclude that up to five farmers would be willing to pay $1200/day. However, it destroys your ability to use the machine to harvest carrots -- it becomes specialized to potato farming. Its only other use would be for non-harvesting-related activities, for which you could receive $500/day.

Define quasi-rents. Calculate the quasi-rents associated with the machine before and after the modification.

Define appropriable specialized quasi-rents. Calculate the ASQR associated with the machine before and after the modification. Are hold-ups likely?

At present, competitive contracting is used to coordinate the provision of farm equipment. Vertical integration is another option. In the context described above, how would vertical integration differ from competitive contracting?

If you decide to purchase and install the new attachment, will the potential for opportunistic behavior likely make vertical integration more efficient than competitive contracting? Why or why not?

9. In the following question, feel free to make any (reasonable) assumptions you wish with respect to facts that are neither described in the article nor below. But state any assumptions you make clearly.

Attached is a news bulletin describing a new alliance between American Airlines and British Airways announced this past Tuesday. This describes a change in how the economic activity that takes place within and between these two airlines is coordinated.

One piece of information that does not appear in the article is the following: airlines have generally been restricted from flying within foreign countries. Traditionally, they have contracted with each other to carry cargo and passengers where they they themselves are not allowed. For example, when a U.S. airline supplies cargo service from New York to a small city in England, it might do so by carrying it from New York to London on one of its own planes, then hiring British Airways to carry it from London to the small city.

How was the economic activity that took place between these two firms coordinated before the strategic alliance? How does it seem that this new alliance will change things? Abstracting from the fact that the airlines' private incentives may differ, is coordination likely to improve as a result? Why or why not?

Are there likely to be incentive conflicts between American Airlines and British Airways after they implement the terms of this new agreement? If not, why not? If so, how are these likely to be addressed?

From your perspective, what are the advantages and disadvantages of this new arrangement? Considering only the interests of American Airlines and British Airways, is this new arrangement likely to be value-increasing or value-decreasing? Why? Under what circumstances would your answer be different?