Economics 174

Problem Set 1 -- Due Friday, April 24
These questions are due at the beginning of class, April 24.  Sample solutions will be available on the web shortly thereafter.

These are designed to be answered in a paragraph or two on the average.  Write as much as you need toward providing a clear and full response to the question, but no more.

If you want more practice with the material, additional problem set questions (from when I previously taught this class) are on the web.  Solutions will be available to these questions as well after April 24.

Good luck!

1. Applying the definition of efficiency, what distinguishes an inefficient organizational form from an efficient one?  Why is there good reason to expect that inefficient organizational structures will not persist in the long run?  Why is this true even when the direct effect of changing organizational structures would  benefit some at the expense of others?

2. Why are contracts incomplete?  Explain why contractual incompleteness can create a situation where individuals make decisions which are not value-maximizing (with respect to the organization).  Describe an activity or institutional feature which organizations adopt in response to individuals' incentives to exploit such situations and gain privately at the expense of others within the organization.

3. Consider a chain specializing in pizza production and delivery.  This chain consists of a central manufacturing plant which produces dough, sauce, etc., and outlets at which pizzas are made and from which pizzas are delivered.  All decisions regarding menus, pizza prices, and so on are made by the CEO of the chain.  Production related decisions are made by managers of the plants and outlets.  Outlet managers can choose whether to purchase raw pizza dough, sauce, etc. from the central manufacturing plant at fixed prices, or to purchase them from outside suppliers at market prices.

4. According to Alchian and Demsetz, why do firms' owners commonly have the right to hire and fire workers?  Explain in your own words.  ( is important here to make a precise argument.)

5. Evaluate the following statement.  Indicate which parts are correct and which parts are not.  If there are incorrect parts, provide alternative text which is correct.

 "Agency costs arise within firms when individuals do not bear the full costs (or reap the full benefits) of their actions.  Agency costs are zero in a one-person owner-operated firm.  They tend to be positive in two-person firms because neither person can be the full residual claimant.  The magnitude of agency costs in a two-person firm can be computed by calculating how much each individual would have produced if they were the sole owner, calculating how much they actually produced, and taking the difference."