Economics 174

Midterm, Fall 95 -- Solutions

1. According to Coase's "The Nature of the Firm," what determines the scope of a firm's activities? (10 pts.)

2. According to Jensen and Meckling, how does debt financing affect the entrepreneur/manager's decisions? That is, why is there a conflict of interest between the manager and debt holders and how would you expect their preferences with respect to projects to differ? (20 pts.)

3. According to the theory presented in class, what group is most likely to gain the most from successful hostile takeover bids: incumbent management, incumbent shareholders, new management, or new shareholders? In one or two sentences, why? (20 pts.)

4. Incentive Schemes and Team Production (50 pts.)

Intercollegiate golf has the following features. Tournaments contain 15-20 five player teams, and last two to four rounds. In each round, all five players play, but only the best (i.e., lowest) four scores count, so a team's score for the round is the sum of four, not five, players' scores. The winning team is that which has the lowest total, which is the sum of the team's scores for each individual round.

Teams play between ten and fifteen tournaments per year. Playing conditions vary in difficulty, because of differences in how hard the golf courses are (some are rated as more difficult than others), what the weather is like, and so on. A common observation is that players' scores are serially correlated, so that given their ability, a good (but not perfect) predictor of players' scores is how they have done in the recent past. Players go through hot streaks and slumps.

My golf team in college had a pool of about ten players available for every tournament. My coach chose the players for the upcoming tournament on a subjective basis, taking into account performance in recent tournaments and in practice rounds among other things.

My coach wanted to provide players additional incentives to practice hard and perform well. (This was sometimes difficult because none of the players were on athletic scholarships, and would continue as students regardless of their performance on the golf course.) Every year, he could take four of us to play a very famous and exclusive golf course that we could not otherwise play. This was a valuable prize to everyone on the team. He told us that he would take the players with the lowest four average tournament scores, where the average taken over the entire season. We believed that he would commit to this rule.

a. What is the performance measure? Are players/workers being evaluated based on their absolute or relative performance? Given that a player/worker plays in a tournament, is this performance measure a good indication of the player's contribution to the team's output? Briefly, why or why not?

b. Does this incentive scheme suffer from the "metering problem" encountered with respect to team production in Alchian and Demsetz? Why or why not?

c. How could the fact that the coach chooses who plays each week, and that playing conditions vary from week to week, undermine this incentive scheme?

d. What improvements would you suggest for this incentive scheme?