Economics 174

Problem Set 4 -- Due Monday, June 3

1. Suppose three inputs are complements. What, if anything, can we say about a firm's demand for each of them when the price of one of them drops?

If inputs are complementary, increases in one of the inputs increase the marginal product of the other input and vice versa. If the price of one of these inputs drop, the firm's demand for all complementary inputs will increase.

2. 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 2.

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.

3. You are the divisional supervisor of a medium-sized fast food chain. Your job is to motivate and monitor the activities of store managers. Store managers must allocate their effort among three (and only three) categories of activities: sales, training, and product development.. Assume that you wish your managers to allocate at least some effort toward all three activities. Stores at which managers expend no effort in one or more of these activites quickly become unprofitable.

You motivate each activity through incentive contracts: you pay them according to a linear compensation scheme that is a function of sales, the number of workers they successfully train, and the number of products they develop that end up in the firm's product line. So far, this has been successful: the incentive scheme motivates the efficient amount of effort in each dimension.

Suppose your company decides to embark on rapid growth, and plans to double the number of outlets during the next five years. You are told by your superior that the managers under your supervision need to expend more effort toward training workers. Your superior suggests that you increase the amount you pay your managers per worker trained. Is this a good idea? Explain.

Probably not. First, doing this alone would cause managers to ignore sales and product development, because incentives would become imbalanced. So this would mean that you would want to change other parts of the incentive scheme as well. Second, given that you are changing all three incentives, it is unclear whether, at the end of the day, it is best to increase all three or decrease all three. Recall that one can encourage training by discouraging (lowering the incentives for) sales and product development.

In general, when the value of effort in one dimension changes, it is unclear which way incentives will move, because you can elicit this effort either by encouraging the activity or discouraging others. If you are constrained to have incentives balanced, whether it is best to make them all stronger or all weaker is unclear.

Suppose instead that your company invents a better means of measuring the contribution of individual manager's effort to sales at their outlet. Should you change the incentives your provide managers? If so, how? If not, why not?

Yes. You should provide stronger incentives for all three activities. When one is constrained to have incentives in balance, incentives are complementary. The direct effect of this better measurement method raises the returns from providing incentives toward output, because it is less costly than it used to be (the costs are in inefficient risk bearing). It does not directly change the returns from providing incentives in the other two dimensions. But the fact that one will increase incentives for output raises the returns from providing stronger incentives in other dimensions -- they are complementary. Therefore, one will strengthen incentives in all three dimensions.

In general, when something changes the value of providing incentives in a certain way, one can indeed predict whether incentives in all dimensions should be strengthened or weakened.

4. The simplest individual life insurance policies have the following characteristics. An individual pays annual premiums to an insurer. When the individual passes away, the insurer pays whoever the individual designated as the beneficiary a fixed amount.

Life insurance is offered in a highly competitive market. Each insurer in the industry maintains vast databases and develops formulas used to price each individual policy. These databases and formulas have been developed and refined over many years by each firm's actuaries, accountants, et al. These formulas determine the prices at which insurers will underwrite individual policies. These prices are complicated functions of individuals' characteristics and the level of coverage they desire. (Coverage can be interpreted as the amount the beneficiary is paid when the individual dies; the price of the policy is the premium.)

Insurers' databases and formulas are extremely important proprietary assets that have a large effect on their profitability. A simple explanation for their importance is that one way of looking at life insurance policies is that they are bets regarding how long individuals will live. Those with better data and formulas are able to place better bets than their competitors, and thus be more profitable. Insurers closely guard these assets. If one firm were to acquire another firm's proprietary data, it could use this data to better price their own policies. For example, if it were to acquire knowledge of another firm's pricing formulas, it could set prices in a way that just barely undercut the other firm's prices when they competed directly for a prospective client's business.

Life insurance is generally marketed and sold through the following three-tiered organizational structure. The top tier is the "home office." Each insurance company maintains a home office which, among its many activities, maintains and develops the insurer's actuarial databases and formulas. The lowest tier consists of insurance brokers -- that is, the salesmen. Each insurer's policies are sold by thousands of salesmen throughout the country. These salesmen are independent agents who are paid solely on commission. Each salesman sells the insurance policies of many different companies. The middle tier is composed of many branch offices. These offices are staffed by employees of individual insurance companies. These individuals recruit agents and provide support to help them make sales. For example, they provide brokers information about the insurer's products, and tips regarding how best to sell them. To some extent, they also oversee brokers' activities.

Insurance is sold in the following way. Brokers meet with prospective clients, and describe the products of the different companies they represent. Once brokers learn of a policy a prospective client is interested in, they telephone one of the insurer's branch offices. The branch office asks the broker to provide information about the client's characteristics and desired coverage level, and runs a program on the home office's computer which generates a price quote. This price quote is generated using the firm's proprietary data and formulas. The branch office then tells the broker the price quote. When a sale is made, the broker sends all of the relevant paperwork to the main office where it is processed. From then on, the main office provides all administrative services relevant to the policy. Salesmen do not provide after-sales support of their accounts.

a) Given that they are relying on independent agents to sell their products, is it desirable for individual firms to pay salesmen on commission rather than a fixed salary? Why or why not?

Yes. Otherwise they would allocate all of their effort toward selling other firms' products rather than yours.

b) Suppose someone invented a means through which brokers did not have to call the branch offices for price quotes: they could instead connect directly to the insurers' computers, type in individuals' characteristics and desired coverage levels, and run the program which generates the price quote. What are the potential advantages and disadvantages from implementing such a system?

The advantage is that you could eliminate branch offices, which are costly to operate. The disadvantage is that you are giving outsiders access to very valuable information. For example, salesmen could dial in and submit many price quotes for fictional clients. If they were sophisticated enough, they could figure out the algorithms, etc., the company uses, and provide this information to its competitors. The key to this problem is to notice that branch offices do not merely serve as information conduits, but also serve as information filters or monitors who prevent such abuses.

c) What organizational changes might accompany this new means of obtaining price quotes? Why?

If a company did install such an application, one would expect to move toward in-house salesmen, who would probably be paid fixed wages.

d) Would you expect that making these organizational changes would be easy or difficult? Why?

This would probably be fairly difficult. First, it changes a lot of individuals' jobs in fairly important ways, so there are probably going to be fairly high adjustment costs. Second, it changes the incentive structures that operate within the firm. When you change incentive structures, there is the difficulty that if you do not get it just right, you may wind up with unbalanced incentives. This would cause individuals to misallocate effort, and possibly be quite harmful -- at least in the short run. Inventing complementary incentive schemes is difficult and costly because of these hazards.