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?

Firms are distinguished by the absence of the price mechanism.  Prices do not coordinate economic activity within firms.

Firms' boundaries are defined as the point at which economic activity ceases being  coordinated by entrepreneurial direction and starts being coordinated by prices.  This occurs at the point at which the cost of organizing an additional transaction "within the firm" (i.e., coordinated by the entrepreneur) equals that of  coordinating it via the price mechanism.  This margin is reached because of diminishing returns to management -- the cost of entrepreneurial coordination rises at an increasing rate with the number of transactions.

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.

This transaction is either "between firms" or "uncertain" depending on how much control is exercised by the telemarketing firm.  If the entire arrangement is described above, then it is "between firms."  Economic activity is coordinated entirely by the price mechanism -- you are being paid a price of $10 per new customer.  If it is the case that the arrangement involves more than this -- for example, if the telemarketing firm can simply tell you to sell product A rather than product B -- than it is uncertain.  Prices would play a role in coordinating the economic activity between you and the telemarketing firm, but it would not be the only institution doing so.  Activity would also be coordinate by direction.

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. 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.)

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."