Problem Set 3 -- Solutions

1. Define quasi-rents. Provide a real-world example of a situation where quasi-rents exist. Under what circumstances would the quasi-rents in your example be appropriable, and what incentive problems might this cause?

Quasi rents are payments in excess of the amount needed to keep an asset in its current use.  Quasi-rents often exist with respect to parking garages.  Whatever their next best use is (rollerblading rink? skateboarding palace?), it is much less valuable than as a parking garage.  Most of the money parking garage operators receive is quasi-rents since what they would receive in its next best use is low.  You effectively rent space when you pay for parking.  Most of what you pay is quasi-rents.

However, it is unlikely that much of the quasi-rents would be appropriable by you, because the parking spaces are equally valuable to other users.  The quasi-rents would only be appropriable if all or most potential parkers banded together and collectively renegotiated the parking rate.  (For example, with respect to UCLA's garages, all faculty, students and staff.)  If this were the case, you could bargain the parking lot manager down to what the "next best user" would be willing to pay.  If the parking lot manager anticipated this, he or she might not build the parking lot in the first place, even though it may be value-maximizing to do so.

2. Attached find materials describing the new compensation program in place at J.B. Hunt, one of the largest for-hire trucking companies in America. Attached also is a press release describing what has happened since the new compensation program went in place.

Several pieces of information will be useful to you. First, the two biggest variable cost items on trucking firms' balance sheets are labor and fuel. Second, "OTR" stands for "on the road" and the pay scale is in cents per mile, where mileage is defined by the shortest distance between drivers' origin and destination. Third, the "current random OTR" was their former pay scale -- one that was about the same as most other trucking firms. "2/25/97 Random OTR" is the new pay scale. Fourth, trucking firms have been under increased pressure from shippers and receivers to pick up and deliver loads on tighter schedules.

Different elements of this compensation program can be explained using several different theories we have come across in class.

J.B. Hunt's objectives are to maximize profits.  Toward this goal, they may choose to offer high quality service to their shippers, and they wish to minimize their costs of production, given the quantity and quality of service they offer.  Individual drivers seek to maximize utility, which is increasing in their income and decreasing in their effort.  They choose effort toward producing higher quantities and toward how they drive.  The objectives conflict because drivers bear the full cost of their effort but generally do not receive the full benefits.  Hence, they will tend to shirk both on quantity (taking longer breaks) and in how they drive (possibly more recklessly, or in a way that does not conserve on fuel). How fast they drive, how long the breaks are, how carefully to drive, how much to help load/unload their truck, etc., etc. I see two important elements.  First, they are paying explicit performance incentives.  They pay drivers by the mile.  The faster the drivers reach their destination, the higher wage/hour and the more hauls they can fit in during the day.  This serves to improve incentives with respect to quantity -- drivers will take shorter breaks and may help load or unload trucks.  However, this may encourage them to drive more recklessly or in a way that wastes fuel.

The other element is that the per-mile wages are higher than at other firms.  They are paying above the competitive wage, and this facet of the compensation scheme has an "efficiency wage" feel to it.  Paying above a competitive wage does two things.  Losing a job at JB Hunt is now costly to drivers.  The threat of firing creates stronger incentives for drivers not to shirk in general -- to take shorter breaks, drive in a way that conserves fuel (assuming fuel consumption can be measured), etc.  Another thing that paying above a competitive wage does is reduce turnover.  Workers will be more reluctant to quit.  This decreases total labor costs if it is costly to train new drivers.

The efficiency wage aspect complements the explicit performance incentives because it provides incentives for drivers to exert effort toward things other than quantity.  Explicit performance incentives generally discourage activities other than what is being directly compensated.  The efficiency wage aspect counters this.

I do not see any problems immediately.  But if other trucking firms decide to match JB Hunt's compensation package, the efficiency wage aspects will not be as effective and this would tend to undermine the value of paying strong performance incentives.  (There may be other problems I do not see at this point -- and I am eager to see what you write.)
When answering these questions, feel free to make any additional assumptions not in the article or the problem, but state them clearly.

3. According to Hart, what defines a firm? Using Hart's theory, explain why GM faced a hold-up problem with Fisher Auto Body during the 1920s, even though GM owned 60% of Fisher's shares. Also using Hart's theory, explain how vertical integration between GM and Fisher alleviated this incentive problem.

A firm is defined by the common ownership of assets used in production, where the owner(s) of an asset is the individual(s) that has residual control rights over it.   For example, the scope of AT&T is defined by the set of assets for which its shareholders have residual control rights.

Using Hart's theory, having 60% of Fisher's shares may not have meant that GM had residual control rights over all Fisher's assets.  This created a hold up problem because Fisher could threaten to withdraw the assets for which it had residual control rights  from the trading relationship.  It may have been able to appropriate the value of any relationship-specific investments made by GM.  Vertical integration transferred residual control rights of Fisher's capital assets to GM, thus eliminating the ability of Fisher's management to withdraw these productive assets from the trading relationship.  GM's relationship-specific investments were more protected from appropriation.

4. Recently, franchisees have brought suit against franchisors, claiming that contractual provisions which limit who they can purchase inputs from are unfair trade practices. Provide an efficiency explanation for such practices. Suppose Congress passes a law prohibiting such provisions in all new franchisor/franchisee contracts. How would you expect contracts between franchisors and franchisees to change as a result? That is, what other contractual provisions would you expect to change?

Efficiency explanation:  limiting who they can purchase inputs from may economize on costs associated with monitoring quality.
Contract changes: The contract would stipulate alternative means of monitoring quality -- perhaps by providing for more frequent store visits, etc.  In order to compensate whomever is directly bearing these greater monitoring costs, franchise fees and/or royalties would be adjusted.  For example, if the franchisor directly bears the cost of additional monitoring, then franchise fees and or royalties would increase.

If the efficiency explanation is correct, such a law would tend to make both franchisees and franchisors no better off than they were before the law, and would make at least one of them worse off.