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?

Efficiency implies that there is no way of changing things such that each individual is at least as well off and at least one is better off.  Therefore, the distinguishing mark of an inefficient organizational form is that it is possible to rearrange things in a way that makes at least one individual better off and none worse off.

Why is there good reason to expect that inefficient organizational structures will not persist in the long run?

At least one individual has an incentive to propose replacing an inefficient structure with an efficient, and by definition can do so in a way that leaves no one worse off.

Why is this true even when the direct effect of changing organizational structures would  benefit some at the expense of others?

Transfers are possible.  Those who are made worse off from the direct effect of the organizational change can be compensated by those who are made better off.  If the initial organizational structure is inefficient, a transfer which does so must exist (by definition).

2. Why are contracts incomplete?

Contracts are incomplete because individuals cannot conceive of all possible states of the world, and even if they could, constructing an agreement which stipulated terms under each possible state of the world would be prohibitively costly.

Explain why contractual incompleteness can create a situation where individuals make decisions which are not value-maximizing (with respect to the organization).

Employment contracts are incomplete -- they do not specify what the employee should do and how much he should be paid in each possible state of the world.  (Part of the reason is that it is costly to determine exactly what the state of the world is -- was the salesman successful because he tried hard or because his customers were pushovers?  More on this later in the class.)  Shirking on the part of the employee can be interpreted as non-value-maximizing behavior.

 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.

Monitoring and incentive contracts are examples.  Incentive contracts are compensation schemes which base pay on performance -- these incorporate commissions, bonuses, etc.

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.

The presence/absence of prices in coordinating economic activity.  Within firms, coordination is "by fiat."  Between firms, coordination takes place via the price mechanism. Different firms.  The transactions between the central plant and the outlets are being coordinated by the price mechanism.  The fact that the CEO of the chain sets the menu and prices of the pizzas is irrelevant by Coase's criteria. Multiple firms.  Nothing changes.  Prices still coordinate the transactions between the outlets and the central plant.

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.)

Alchian and Demsetz argue that it is efficient for the right to hire and fire workers and residual claimancy to be held by the same individual.  Allocating personnel decisions to the residual claimant is efficient because the residual claimant appropriates the full benefits from any marginal improvements to productivity.  He or she has incentives to a) assemble a team of high ability, and b) monitor individual inputs at efficient levels.

The general principle they apply is that decision rights should be allocated to individuals with the strongest incentives toward value-maximization.  This is an extremely general principle which is applied over and over again in economic analyses of organizations.

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."

All but the final sentence is correct.  The final sentence is correct if one replaces "agency costs" with "residual loss."  Agency costs include monitoring and bonding costs -- the value of any resources devoted toward incentive alignment -- as well as residual loss.

To make the statement correct, I would replace the final sentence with the following text:

"The magnitude of agency costs are equal to monitoring costs, bonding cost, and "residual loss."  In a two-person firm, "residual loss" can be computed by calculating how much each individual would have produced if they were the sole owner, calculating how much they actually produced given the monitoring and bonding activities which were actually implemented, and taking the difference."


"The magnitude of agency costs can be computed by calculating the value of the firm, assuming that incentive conflicts could be eliminated costlessly, the value of the firm in practice, and taking the difference."