Economics 174

Problem Set 1 -- Due Wednesday, April 21

These questions are due at the beginning of class, April 21.  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 21.

Good luck!

1. According to Coase, what distinguishes firms?  What determines a firm's boundaries?

Suppose a telemarketing firm offers you a position as one of those people that calls homes during dinnertime, offering whomever answers special offers on credit cards.  This firm pays you purely on commission -- say, $10 for every person that signs up.

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. One of the trends in business during the past ten years or so is the increasing use of electronic data interchange, or EDI. In electronic data interchange, firms use computer networks or dial up connections to exchange information such as invoices, orders, delivery confirmation. These replace previous processes in which such information was exchanged using phone, fax, or even mail-based systems. One advantage is that they permit the timely exchange of data. Another is that they can be linked to firms' internal computer systems so that individuals do not have to rekey information when it comes in. A drawback is that they often require firms to purchase considerable amounts of new hardware or software, and they can require them to make costly changes to their existing business practices to take full advantage of the new capabilities.

Suppose we are considering whether a specific supplier and manufacturer will adopt this new technology.

Suppose that the manufacturer anticipates that the new system will generate production improvements that will greatly outweigh the cost savings, but that the supplier anticipates that the new system will not "pay for itself."

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."