This exam has four questions.  The first two count 15 points apiece.  The third and fourth count 10 apiece.  50 points, 50 minutes.  Allocate your time wisely.

This examination ends at 9:50.  You may work past 9:50, 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.    High yield ("junk") bonds were sometimes used to finance corporate takeovers during the 1980s.  In class, I related the received wisdom that there was a relationship between the emergence of junk bonds and the fact that many large firms were subject to takeover bids.  Junk bonds enabled small firms to obtain financing to take over much larger firms.  Taking over such large firms is risky, and so-called investment grade bonds promised too low a return to finance such an enterprise.

This explanation, however, is incomplete.  It does not explain why takeovers tended to be financed with junk bonds rather than through new equity issues.  Firms engaged in takeovers could in principle do so by selling new shares.

One explanation is that if a takeover is successful and generates large efficiency gains, a problem arises with respect to how these gains are allocated.  Agency problems exist between the (new) managers of the firm and their shareholders.  The managers may attempt to keep a disproportionate share of the gains -- perhaps via perquisite-taking -- rather than distributing them back to their shareholders.  Debt financing may be efficient relative to equity financing because it commits managers to a periodic distribution of earnings back to shareholders.  This is an example of what Jensen calls a "free cash flow" problem.

Remark: One may be able to do this via equity financing as well.  Managers could announce a dividend policy which mimics debt payments.  But dividend policy can change at managers' discretion.  Debt payments may involve a stronger commitment.

2.     A survey of cab drivers in LA reports the following phenomena.  On average, drivers who own their own cabs pay their company 25% of the fares they receive.   In contrast, drivers who drive cabs owned by their company are pay their company 75% of the fares they receive.  The survey also reports that base wages tend to be higher for companies who drive company cabs than those who drive their own.

One explanation has to do with balanced incentives.  Suppose drivers choose both how fast they drive and how carefully they drive.  If they do not own their own cab, they may allocate effort toward driving fast and away from driving carefully.  Providing strong output incentives in the form of a high piece rate may be costly in such circumstances because it induces a misallocation of effort.  When drivers own their own cabs, they already have strong incentives to drive carefully.  Paying them strong incentives for output brings incentives more into balance, not less.  This means that paying strong performance incentives is less costly when drivers own their own cabs.

One cannot say much about base wages in this case.  Assume competitive labor markets for both sets of drivers.  If both were paid the same CEQ, the base wage of drivers who own their own cabs would tend to be lower (because they are earning more in commissions).  However, part of the wage of drivers who own their own cabs would compensate them for the use of their cab -- sort of a rental payment.  So this would have the opposite effect, pushing the base wage up.  The important part of the question concerned the performance incentive, not the base wage..

 In LA, customers tend to "hail" cabs by calling in to a cab company and requesting service.  In New York, they tend to hail them by standing on street corners and indicating that they need a cab.

Profits are more a function of driver effort in NY.  Therefore, the optimal incentive contract would tend to pay a lower royalty to the company (that is, stronger performance incentives)..

3.     Define "complete contract."

An agreement that specifies the actions each agent must take and the transfers that must be made in each possible state of the world.

4.     Describe conditions whereby bargaining alone will necessarily lead to the implementation of efficient arrangements.