Economics 174

Problem Set 3 -- Due Wednesday, May 15

Problem Set 3 -- Solutions

1. Define rents. Describe a situation where rents exist within a firm or other organization. Why might it be desirable to limit rent-seeking behavior within organizations? Are arrangements where rents do not exist necessarily more efficient than arrangements where they do exist? Why or why not?

Rents are payment in excess of the amount necessary to draw an asset into its current use. Rents exist, for example, when a worker is paid above what it would take to get him or her to accept a job. Rent-seeking activities (activities which result in private gains but do not add value) are generally undesirable because resources are being diverted from activities that add value toward those that do not. Arrangements where rents do not exist are not necessarily more efficient than those where they do not. We described how in some circumstances allowing workers to earn rents through efficiency wages can provide good incentives. In some circumstances, this might be the efficient means of compensation.

2. Some incentive contracts base individuals' pay on how they perform compared to other individuals in similar jobs. Why might it be desirable to do so? What sources of inefficiencies arise that do not appear when firms base pay only on measures of individuals' absolute performance?

Basing workers' pay on their performance relative to others can reduce the variance of the performance measure by "differencing out" common factors. Common factors are elements outside of workers' control that affect the performance measure of each. Several new inefficiencies arise from basing one individual's pay in others' performance measures. First, if others' performance measures are related to factors outside of their control that do not appear in the individual's own performance measure, there is an additional source of variance. If workers are risk averse, this is costly. Second, if workers can affect each others' performance measure, relative performance measures provide incentives toward wealth destroying activities such as sabotage. Or, workers may simply cooperate less than they otherwise would.

3. Why might franchisees' interests differ from franchisors' interests? How might this be manifested in franchisees' behavior? How might this be manifested in franchisors' behavior?

Franchisees and franchisors have different private objectives: each maximizes some measure of their private welfare (utility, income, profit, etc.). These generally differ. Franchise agreements imperfectly resolve the conflict of interest associated with the fact they share the benefits from any increases in the value of their common brand name, but each privately bears the cost of any resources devoted toward enhancing its value. Conflicts of interest are manifested in the fact that franchisees may shirk on quality, cleanliness, etc. of their outlets, and that franchisors may shirk in the amount or quality of advertising they purchase.

4. Imagine that you are consulting Henry Ford during the 1910s. He had successfully introduced the $5 day; his workers were earning well above what they could earn in their next best opportunity. Ford calls you in, and says that he is concerned about demographic changes in his workforce. The region's healthy economy was providing strong incentives for young men from Europe to immigrate near his auto plants in Michigan. While his workforce did not change in any other way, it was, on the average, two full years younger than it had been when Ford had initially (optimally) set wages for workers at $5/day and hired 100 supervisors to monitor workers. His policy, as always, was to fire (and never rehire) any worker who was found shirking. Assume that all Ford workers, as long as they were never found shirking, continue to work there until they reach a mandatory retirement age of 65.

In talking to Ford, you learn that he is particularly concerned about two matters. First, he is concerned that because his workforce is younger, if he happens to hire a shirker, this shirker may end up working at Ford for a longer time. So he is considering whether to hire more supervisor/thugs to monitor his workforce. He is also considering cutting the daily wage. Ford's reasoning is that it may make sense to do so because it would make the lifetime wage premium he would pay workers (on the average) the same as it was before this demographic change.

What do you recommend to Ford with respect to changes in the wage and the number of supervisors, given that he wants to minimize his total labor costs and deter shirking?

On the average, the number of periods "to go" in the relationship increased by two years. This means that the optimal wage premium decreases, and the optimal level of monitoring decreases, from the discussions in class and from Milgrom and Roberts. Ford should decrease the wage (although not for the reason he gave) and fire a few supervisors.

5. In order to attract candidates from liberal arts universities without formal accounting majors, the big six accounting firms run a special program in conjunction with New York University's Stern School of Business. Liberal arts majors who are hired must attend school during summers and at night for two years. The employee must pay for this schooling; assume that it costs $5,000. After they finish their courses, employees take the CPA exam. During they time they are going to school (and working), employees are paid $35,000/year. Classes are composed entirely of new employees of big six accounting firms. Because they are in the midst of receiving exactly the same training, it is common for new employees to switch firms during their first two years. Effectively, each of these trainees always has the opportunity to switch to a different big six accounting firm and be paid $35,000/year.

During March of my senior year at school, my two most attractive offers were from a big six accounting firm and an economics consulting firm. The big six accounting firm's offer is described above. The economic consulting firm's offer was $25,000/year. Assume that the consulting firm has a policy of not hiring anyone who has ever worked at an accounting firm (it is extremely costly to retrain accountants to do good economic analysis). My next best opportunity was earning $22,000/year at a health care management firm in New York. This offer would stay open for the foreseeable future, and it would remain better than any other opportunity.

Assume that I care only about my net income. I therefore choose to work at the accounting firm. How much, if anything, of my starting salary can be considered an economic rent? How much, if anything, of my starting salary can be considered a quasi-rent? Do there exist appropriable specialized quasi-rents? If so, how much? If not, why not? Is there a hold-up problem?

Rents are payments in excess of what it would have taken to make me an accountant rather than an economic consultant. According to the assumptions above, I would have been indifferent between the two jobs if the accounting firm offered $30,000 ($35,000-$5,000) in salary. Therefore, $5,000 of my salary should be considered rents. Quasi-rents are payment in excess of the amount it would take to keep me an accountant. My next best oppportunity (after I accepted the accounting job) was earning $22,000. Therefore, quasi-rents equal $8,000. None of these are appropriable, because if the accounting firm I was at tried to appropriate even one dollar of this, I would simply switch to another accounting firm. There is no hold up problem.

Suppose the accounting firms get tired of turnover among their new employees, and announce a policy of not hiring trainees away from each other. Does this change the answers to the above questions? Explain.

Yes. The quasi-rents are now entirely appropriable. There is now a potential hold up problem. The accounting firm I worked for might be able to force me to renegotiate my salary down to $27,000/yr. If I saw that this was going to be the case, I would either a) devote resources toward keeping this from happening, or b) not take the job at the accounting firm.