Economics 174

Midterm, Spring 1996 -- Solutions

1. (10 pts.) Identify the three components of the agency costs associated with equity financing.

Monitoring costs, bonding costs, residual loss.

2. (10 pts.) According to Coase, what determines the size and scope of the firm?

Economic activity is either coordinated via the price mechanism or by fiat. There are costs to both. Which is chosen for each individual transaction depends which is less costly. Transactions coordinated by fiat are "within the firm." Coase posits that the marginal costs of coordinating by fiat increases in the number of transactions. At some point, coordination via the price mechanism or within a different firm becomes less costly. This limits individual firms' size. The point at which the marginal cost of organizing an additional transaction within the firm is more expensive than within the market or another firm determines firms' size and scope.

3. (10 pts.) "Groupware" computer programs such a Lotus Notes can permit supervisors to better monitor individual workers -- particularly white-collar workers. For example, supervisors can use the software to remotely view the document or spreadsheet file individuals are working on, and watch as individuals type in characters.

Assuming that workers care only about their income and effort levels, and that their preferences exhibit no wealth effects, is this new monitoring capability likely to make individual workers better off, just as well off, or worse off? Why?

This turned out to be the hardest question. The answer could be any of the above, depending on the assumptions you make. Your grade depends upon the strength of your argument. The most appropriate answers were either that workers were just as well off, or were made better off. This result descends from the arguments made in Alchian and Demsetz: monitoring can make team members better off. You could also say that workers were made worse off, but you would need to say more than "monitoring means that workers shirk less, and working harder for the same wage makes them worse off." (Why would they be willing to accept the same wage and work harder?)

Assume first that labor markets are competitive, so workers start off making their reservation wage. They are just indifferent between their current job and their next best opportunity. Then monitoring cannot make them worse off -- if the new arrangement made them worse off, they could simply quit and be just as well off as they started at their next best opportunity.

The new monitoring technology permits better alignment of agents' and principals' incentives. Thus, agency costs are lower and the arrangement is more efficient -- it is value-increasing. The only question is how the gains are shared. It may be the case that firms can achieve all of the gains -- they can offer a new (higher) wage that makes workers indifferent between their suddenly more monitored job and their next best opportunity. In this case, workers are just as well off, but not better off. If workers have any bargaining power they may be able to share in the efficiency gains. If this is the case, they will be better off.

In order for workers to be made worse off from the new technology, they would have had to be doing better than their next best opportunity to begin with. Firms must not only be appropriating all of the gains from the reduction in agency costs, but must be taking away some rents from workers, where rents describe the difference between what a worker is paid and what he or she is willing to work for.

4. (20 pts.) On the next page are excerpts from a column that appeared in the Los Angeles Times a week ago Sunday. Read these excerpts and answer the following questions. Assume that stock options represent highly uncertain streams of income. Assume also no wealth effects in individuals' preferences.

a. What are the economic benefits in offering stock options to all employees? Is Elaine Franklin right when she says that doing so aligns "employee interests with those of shareholders"?

Better incentives for workers. Pay is now correlated with effort, albeit weakly. In this way, this scheme does better align workers' and shareholders' incentives.

b. What are the economic costs in doing so?

The main economic cost is that it shifts risk from those for whom it is not costly to those for whom it is, assuming that workers are risk-averse. Other costs include the cost of the additional effort the incentive scheme elicits, and the cost of setting up and running the compensation plan. c. Microsoft, unlike other software companies, pays many of its employees in part in stock options. All else equal, would you expect salaries at Microsoft to be higher, the same, or lower than at other software companies?

Average total compensation would be higher to account for the additional risk. Salaries (fixed payments), however, would likely be lower.

(They would only be higher if the risk premium associated with the options was extremely high. For example, if the workers were so risk averse that they valued the average income they derive from the options less than their cost of bearing the additional risk.)

d. You are hired by a large manufacturing firm as a compensation consultant. Your task is to design efficient incentive contracts. Would you recommend that assembly line workers be paid in part in stock options? Why or why not? Does your answer depend on the fixed wage these workers receive?

It is extremely unlikely that paying assembly line workers in part in options is efficient. The benefits are very small -- each individual worker's effort affects the value of the options by an incredibly small amount. It is unlikely that options would provide very strong incentives to these workers. The costs are quite high, because you are now exposing workers to a lot of risk -- their pay is now a function of factors outside of their control. This answer does not depend on the fixed wage; under no wealth effects, transfers have no efficiency implications.