Problem Set 3 -- Due May 29, 1998

Econ 174
Spring 1998
Thomas Hubbard
Problem Set 3 -- Due May 29, 1998

1. Define quasi-rent. Describe a situation where quasi-rents are exist, but not appropriable. In such a situation, does the existence of quasi-rents provide an motivation for vertical integration? Explain.

Quasi-rent: Payment in excess of the amount needed to keep a resource into its current use.

Suppose I own a hollow-hulled ship. I presently rent it to a firm for $150,000/year for the purposes of carrying oil. Other firms are also willing to rent it for $150,000/year to carry oil, and because they are located right next door to the first firm, it is costless for me to change the firm to which I rent it. Suppose the ship is practically useless if it does not ship oil -- non-oil-hauling firms are willing only to pay $10,000/year. In this case, quasi-rents equal $140,000/year, but none of the quasi-rents are appropriable.

In this situation, there is no hold-up problem because there is no threat of appropriation. The existence of quasi-rents does not provide a motivation for vertical integration.

Note 1: If the quasi rents were appropriable (other oil haulers were only willing to pay $100,000, for example), then quasi-rents would indeed provide an incentive for vertical integration.

Note 2: Vertical integration in this case implies that the same firm that builds or provides the ship also operates the ship.

2. In class I briefly mentioned that Alchian and Demsetz' analysis sheds some light on organizational issues faced by retail chains.

What decision rights are commonly held by franchisors within franchising agreements?

Decision rights held by franchisors often include where to place new outlets, whether to approve new owners, whether to terminate existing franchises, which input suppliers to approve, what products to sell, how closely to monitor individual franchisees, national advertising quantity and content (although not Subway).

Applying Alchian and Demsetz, why do franchisors hold these rights rather than individual franchisees?

Alchian and Demsetz' analysis proposes that incentive problems that arise in the context of team production may be mitigated through the appointment of a centralized monitor. This monitor is the only one in the organization with the right to terminate membership in the team (or to bring on board new members).

One can consider chains of outlets as members of a team, each of whom has incentive to free ride on the efforts of other members. One can think of franchisors as specialized monitors. The right to terminate franchise agreements is analogous to the right to alter team membership. Many of the other decision rights noted above, especially the decision how close to monitor franchisees, can be interpreted as instruments designed to prevent free riding at the outlet level. (Outlets could choose to order shoddy inputs, discontinue certain menu items, not advertise much or well, etc.)

Applying Alchian and Demsetz, franchisors hold this set of rights to improve their ability to serve as specialized monitors.

Who "monitors the monitor" within franchise chains?

The market. Shirking by the franchisor is reflected in potential franchisees' willingness to pay for new franchises. Therefore, shirking is reflected by the price franchisors receive for franchises.

Do franchising arrangements serve to eliminate all incentive conflicts? Explain.

No. First, franchising agreements are incomplete contracts, and incomplete contracts never eliminate all incentive conflicts. Franchisors cannot perfectly monitor franchisees, and consequently cannot create and enforce agreements conditional on every possible state of the world. Second, the market does not always serve as particularly good monitor to deter franchisors from shirking. This is particularly the case when the chain is no longer growing -- drops in the amount individuals are willing to pay for new franchises would matter much less to the franchisor.

3. Using efficiency wage theory, explain why the salary of a 60-year old executives might be higher than the salary of 45-year-old executives who are equally talented and knowledgeable and whose outside opportunities are exactly the same.

Does efficiency wage theory provide a coherent explanation for why compensation generally increases with age for salaried workers? Why or why not?

60-year olds are close to retirement than 45-year olds. "N" -- the number of periods to go in the relationship -- is lower. Therefore, in order to satisfy the executive's "no shirking constraint," one would have to pay the 60-year-old a wage such that the differential between it and his/her next best opportunity is larger.

By a similar logic, efficiency wage theory provides a coherent explanation for why compensation generally increases with age for salaried workers. One has to pay them more and more to satisfy their no shirking constraint.

This is not the only possible theory for the relationship between wages and age. But it is a theory that is consistent with the facts.

4. Firms use various types of trailers when hauling goods by truck. Two examples are "basic vans" and "grain bodies." Basic vans are used to haul general freight: goods which are packaged in boxes and which are not temperature-sensitive. (These are the familiar box-like trailers you see on the road.) Grain bodies are trailers which have no top, but have sides which are reinforced by layers of steel that can withstand large amounts of pressure from inside.

To what degree are basic vans specific to uses? To users?

Basic vans are not very specific to uses -- one can use them to haul many different commodities. They are specific to users to the extent that it is costly to find and transport the trailer to a new user. Such costs are not very large in circumstances where there are many shippers who can potentially use basic vans. (They would be larger -- and basic vans would be more specific to users -- say, in the middle of the desert.)

To what degree are grain bodies specific to uses? To users?

Grain bodies are specific to uses -- they lose a lot of their value if they are not used to haul grain. Like basic vans, they are specific to users to the extent that it is costly to find and transport the trailer to the next best user. In circumstances where there are many shippers which haul grain by truck, they are not very specific to users. In circumstances where there are few such shippers (or a low density of such shippers), they tend to be relatively specific to users.

Hubbard (1998) finds that nationwide, about 35% of hauls which use basic vans are completed by private fleets -- circumstances where manufacturers, distributors, retailers, etc., hauls their own goods. The rest are completed by for-hire trucking firms. In contrast, 75% of hauls which use grain bodies are completed by private fleets; only 25% are completed by for-hire fleets.

Interpret these facts in light of one or more of the theories presented in class and/or in the readings. You may either do so by outlining a theory which explains the facts, or by explaining why the facts are inconsistent with the theories we have encountered.

These figures imply that competitive contracting is generally used when hauls require basic vans. Vertical integration is more the rule when hauls require grain bodies.

This is quite consistent with Klein, Crawford, and Alchian. Grain bodies are more specific to users. Lower density of users implies that it is more costly to find and transport the trailer to alternative users than for basic vans. Under competitive contracting, this implies that appropriable quasi-rents would tend to be greater for grain bodies than for basic vans. Vertical integration would hence tend to be efficient relative to competitive contracting more frequently for hauls using grain bodies than for those using basic vans.

[I operate a trucking company. Someone phones me up. We agree on a price. I drive the tractor-trailer to your door. Once I do so, it is costly for me to find and serve other shippers -- the more distant the alternative shipper, the more costly it is. If the alternative shipper is right next door and you try to renegotiate the price, I simply serve the shipper next door. If the alternative shipper is halfway across the state, you may well be successful in your renegotiation. The hold-up problem appears in the latter case but not the former, because the proximity of the alternative user affects the extent to which quasi-rents are appropriable. Alternative users tend to be more nearby for trailers which can be used to haul many commodities.]

Further research indicates that 55% of hauls which use grain bodies in Iowa are completed by for-hire trucking firms, but 5% of hauls which use grain bodies in Oregon do.

Is this a surprise, in light of what we have discussed in class? Why or why not?

Much grain is grown in the state of Iowa. Little grain is grown in Oregon. Alternative users would be easy to find and geographically nearby with respect to grain body trailers in Iowa. They would be harder to find and geographically more distant in Oregon. Appropriable quasi-rents would be greater in Oregon than in Iowa. This implies that competitive contracting would tend to be efficient more frequently in Iowa, but not Oregon, with respect to hauls using grain bodies.