Economics 174

Problem Set 4 -- Solutions

1. Williamson asserts that opportunism does not pose the same difficulties for transactions within firms as it does for transactions between firms. This is not uncontroversial. Why does he believe that this is true?

He provides three reasons: common ownership of assets limits incentives for individuals within firms to be opportunistic, internal organization is able to use authority to direct behavior, and individuals within firms are likely to be better informed about conditions or be better able to monitor behavior than those in different firms.

In light of what you have learned in the class to date, do you believe his position is reasonable? Why or why not? [There is no single right answer to this part of the question, but this does not give you free rein to argue unconvincingly...]

People generally did a good job here.

2. Define asset specificity. Provide examples of site specificity, physical asset specificity, and human asset specificity not provided in class or in articles. If you feel that any of your examples may be too subtle for me to see at once, explain them.

Asset specificity is the extent to which the value of an asset is lost when it is utilized outside of a certain context. Most of you came up with nice examples, particularly for site and physical asset specificity. Regarding human asset specificity, however, it is generally not enough just to say that when someone has a special talent (ballet dancer, basketball player, economist) there is a high degree of asset specificity. The value of their talent has be reduced when it is utilized in a different context. For example, one student said that Michael Jordan's talents had a high degree of specificity. However, it is likely that while Jordan's talents are specific to basketball and valuable to his current team, they are also very valuable to other teams as well. My talents as an economist have a low degree of specificity; my talents in teaching Econ 174 are quite specific because few universities offer this course.

3. What is horizontal free riding? Why is it a problem addressed in franchising contracts? What elements of these contracts address this problem?

Horizontal free riding occurs when parties at the same level in the supply chain share the use of a single asset. The free riding problem arises because the parties do not internalize the benefits from actions taken toward maintaining this asset. It is a problem addressed in franchising contracts because the individual stores share a reputational asset conferred by their brand name or business format. Quality monitoring and other operational restrictions serve to address this problem.

4. True, false, or uncertain: Klein and Saft view all tie-in arrangements as efficiency-reducing. Explain your answer.

False. The authors demonstrate that some tie-in arrangements may be value increasing because they economize on monitoring costs.

5. During the late 1880s, new, more efficient, means of producing (packing) meat were invented. Relatedly, Chandler writes that: "In 1882, Gustavus F. Swift, a Chicago meatpacker...began to build a nationwide distributing organization which owned, besides many [refrigerated railroad] cars, a network of refrigerated warehouses that also served as branch offices for the company's wholesale marketing forces."

From the analysis in class and in the readings regarding asset ownership and organizational change (two different topics), what forces provided Swift the incentive to a) own his own refrigerated railroad cars (as opposed to the railroad owning such cars), b) integrate downstream into the distribution and marketing of his meat? What other investments would you expect that Swift made at approximately the same time and why?

Refrigerated railroad cars are a specific asset -- if the railroad owned them, Swift could hold up the railroad and opportunistically demand lower rates than those agreed upon in the original contract. From the analysis in Chandler, Swift would integrate into distribution and marketing of his meat in order to capture economies of scale in production. Integration aided this by helping maintain a constant flow of inputs through the production process. Also from Chandler, one would expect that Swift would invest in a more sophisticated organizational structure and hire middle managers to coordinate input and output flows.

6. If two inputs are complementary, then what can we say about their marginal products? Suppose three inputs are complementary and the price of one of them drops. What, if anything, can we say about the firm's demand for the other inputs?

If inputs are complementary, increases in one of the inputs increase the marginal product of the other input and vice versa. (It is not correct to say "the marginal products are correlated". This is not a meaningful statement. Also, the "and vice versa" part is very important.) If the price of one of these inputs drop, the firm's demand for all complementary inputs will increase.

If two technologies are complementary, then they are innovationally complementary as well. What does this mean? In what sense were innovations between 1850 and 1900 complementary?

Innovational complementarities occur when innovations in one dimension raise the return from innovations in other dimensions. Innovations during this time were innovationally complementary because technological developments in one area tended to increase the returns from technological improvements in other dimensions, and vice versa. For example, improvements in organizational hierarchies raised the returns from new mass production techniques, because one could better maintain throughput at efficient scales. Improvements in production techniques raised the returns from organizational inventions -- sophisticated organizatinal structures had little value when production was "artisan production" that typified the pre-1840 time period. (Note that this answer explains the complementarity in both directions!)