This exam has three questions.  The first two count 15 points apiece.  The third counts 20.  50 points, 50 minutes.  Allocate your time wisely. 

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.  Good luck! 



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.  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. 



2.  Professional athletes often contractually agree not to engage in dangerous activities such as skydiving or skiing during the life of the contract.  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. 



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. 

[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 the click-through. 

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. 

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.