Economics 174

Problem Set 4 -- Due Monday, June 8

2. According to Nelson and Winter, why would management be more difficult for firms in industries where there are intermittent, unanticipated breakthroughs in technological capabilities (for example, in biotechnology) than in those where technological capabilites remain relatively constant over long periods (for example, in sugar production)?

3. Mechanics, hair stylists, plumbers, and dentists may not share much in common personally. But they do share several features professionally.

All are service-providers, and provide services for which quality is hard to define or measure, particularly at the time services are supplied. For example, it is hard to judge right away how long auto repair, plumbing, or dental work will last. It is hard to judge how good haircuts look a day or a week later once hair grows out.

All tend to be independent contractors. Even when they are associated with a firm, the arrangement is independent contractor-like. For example, when one calls a dental group for an appointment, one generally arranges for an appointment with a particular dentist. Receptionists or office managers do not generally allocate work across dentists. One way of thinking about this is that individual mechanics, hair stylists, plumbers, and dentists "own their clients" -- even when they are associated with a firm.

All tend to be paid a function of the work they complete. This is obvious when they work independently. But it is true even when they are associated with a firm.

All tend to own many of their own tools, even when they are associated with a firm. Many hair stylists may work in a salon, but each usually owns their own scissors, razors, etc.

Discuss why individuals in these professions tend "own their clients," are paid mainly as a function of the work they complete, and tend to own many of their own tools.

[When thinking about your answer, it may help to consider why the opposite does not happen -- that is, think about what would happen if auto repair firms "owned clients," mechanics were not paid commissions, and mechanics did not own their own tools. If doing so does not help, though, feel free not to do this.]

4. Salespeople at retail apparel stores generally have several responsibilities. One is that they are responsible for serving customers and encouraging them to purchase goods. Another is that they are responsible for keeping the store looking good. Part of this involves restocking clothes and making sure they are displayed neatly, either on hangers or folded on a shelf. It generally takes little effort to make clothes on hangers look neat; it takes much more effort to make stacks of folded clothes look neat.

Assume the following. Managers of apparel stores care both that individual salespeople sell clothes and undertake effort toward ensuring that their stores look neat. It is relatively easy for managers to keep track of the sales generated by individual salespeople. Because of this, it is feasible to reward salespeople with commissions. It is extremely difficult for them to develop measures of how neat displays look. It is so difficult, in fact, that it is impossible for them to directly reward salespeople on the basis of how well they maintain displays. While payment on commission indirectly provides salespeople incentives toward maintaining displays -- they sell more if their store looks nicer -- these indirect incentives are extremely weak, weak enough to be ignored completely. Any effort expended by salespeople toward maintaining displays primarily comes from their pride from working at a nice-looking store.

Hidayatallah (1997) surveys 37 retail apparel stores in the South Coast Mall, and finds the following. First, slightly over half of the stores pay their salespeople commissions. Second, there is a negative correlation between paying salespeople commissions and the fraction of clothes in the store that were displayed folded. That is, stores which displayed a high fraction of their clothes folded tended not to pay their salespeople commissions. In contrast, those which displayed most of their clothes on hangers tended to pay them commissions.

Applying Holmstrom and Milgrom theory, explain Hidayatallah's second finding.

At some retail stores, "team-selling" is used. For example, different employees greet, serve, and ring out customers. Would you expect commissions to be more common at stores which "team- sell" than those at which single salespeople greet, serve, and ring out customers? Why or why not?