Economics 174

Problem Set 2 -- Due Wednesday, October 25

1. Shareholders of large corporations appoint boards of directors to monitor managers. Why might such monitoring be ineffectual?

2. True or false: Agency costs are manifested solely in the amount by which the agent's choice of actions differs from that which would be chosen if their actions could be perfectly and costlessly observed by the principal. Support your answer.

3. According to Jensen and Meckling, who bears the costs of agency that result from owners financing projects by issuing equity? Why is this the case?

4. How does a deductible in insurance (a provision in which individuals are not covered for small losses) align the incentives of the insured and the insurer? What economic problem are deductables a response to?

5. When a workers' effort is not directly observable, it may be desirable to pay them on the basis of output rather than their labor, particularly when output can be attributable to individual workers. While this may provide performance incentives that lead them to work harder, this may have drawbacks. Describe at least two.