April 28, 1997
This exam has three questions. The first two count 15 points apiece.
The third counts 20. 50 points, 50 minutes. Allocate your time
This examination ends at 10:50. You may work past 10:50, but at a
price of 2 points per minute. This rule will be strictly enforced.
If you have any questions please go out into the hall and ask me there.
Clear, concise, and correct answers are best. Think before you write.
1. State the Coase Theorem.
If a) bargaining is costless and b) individuals' preferences do not
exhibit wealth effects, then the outcome of bargaining/contracting will
be determined solely by efficiency, regardless of the initial allocation
of property or decision rights.
It tells us what must not be true for institutions to have efficiency
explanations in cases where the terms of trade are determined through bargaining.
For example, it highlights the role of transaction costs.
Why is it relevant for the study of organizations?
Any circumstances where bargaining is costly would work here.
If individuals value time and delay is costly, the "no transaction
cost" assumption is violated. Suppose a firm is negotiating
with one of its suppliers over the terms of trade, but if negotiations
take too long the firm loses an opportunity to sell its product.
Then bargaining will not necessarily lead to an efficient outcome.
Provide a real world example in which one or more of the Coase Theorem's
assumptions is violated.
2. Professional athletes often contractually agree not to engage
in dangerous activities such as skydiving or skiing during the life of
No, this is not surprising. This is like the situation in Jensen
and Meckling in which entrepreneurs issuing equity or debt enter into covenants
in which they agree not to undertake certain activities. If such
an agreement is part of an efficient contract, it is in all parties' interest
that it be implemented. Just as the entrepreneur in Jensen and Meckling
will receive a higher price or lower interest rate for the equity or debt
he is issuing, the athletes will likely receive higher compensation when
they agree to such limits.
Is it surprising that the athletes themselves may propose such a contractual
term, even though it places limits on their own behavior? Why or
3. Newspapers base advertising rates in part on circulation: the
number of copies that are sold or given away as promotions. This
is particularly the case when advertisers agree to purchase large quantities
of advertising over a significant period of time. One reason advertising
rates are based on circulation is that doing so provides newspapers incentives
to produce high quality products that people will buy and/or read.
Agreements between newspapers and advertisers can be interpreted as incentive
contracts; the rate advertisers pay per reader can be interpreted as a
sort of performance incentive.
Recently we have seen the emergence of on-line newspapers on the world
wide web, and advertisements have begun to appear on web pages. Unlike
print ads, readers can click on these advertisements to obtain further
information about the advertiser.
If all the advertiser cared about was the number of people who were
exposed to the advertisement, one would not want also to base rates on
click-throughs. But advertisers care about more than the number --
they care about which segments of the population see the advertisement.
And they want to provide newspapers incentives to provide content that
attracts particular audiences for their advertisements. For example,
mutual fund companies which advertise on the Wall St. Journal's web site
want the pages on which their advertisements appear to be particularly
attractive to people with money to invest (not assistant professors and
students!). Basing rates on "click-throughs" provides newspapers
incentives to supply content that attracts individuals who are more prone
to seek additional information about advertisers' products.
Discuss whether it would be efficient to base advertising rates not
just on the number of people that observe pages with advertisements, but
also on how many of them "click through" for further information.
Why would or it would not be efficient to do so?
[You are welcome to make any (reasonable) assumptions you need about things
not otherwise stated in the problem. Just state them clearly.]
[As an aside, it might also provide bad incentives to the newspaper
-- it may provide them an incentive to hire people to access their web
site and continually click through! It also somewhat weakens advertisers'
incentives to provide attractive advertisements on web pages, because they
pay some amount per click through. Perhaps the advertisement will
instead direct the potential customer to the advertiser's web site by simply
stating the site's address, thus avoiding the commission they have to pay
per click through. It might be efficient to make the newspaper responsible
for the design of the advertisement, given that they are being paid by
These examples point out the difficulty in constructing incentive contracts.
Incentive contracts may motivate individuals or firms to undertake non-value-maximizing
activities if not constructed carefully.]
The informativeness principle refers to how one should incorporate outside
information into a statistic upon which one bases performance incentives.
It states that outside information should be used to the extent that it
improves this statistic -- that is, to the extent that it makes the statistic
most indicative of the agent's effort. This is the "gamma"
we derived in class.
Using the informativeness principle, are there any other pieces of
information that one might wish to incorporate into advertising rates for
web-based pages? What are they, and why would it be efficient to
So anything that is correlated with those factors outside of the newspaper's
control and which affect the number of people who access the web page is
something that one might incorporate into advertising rates. For
example, if it were weighted appropriately, incorporating the number of
people with web browsers into the performance statistics would improve
the incentive contract.