Exam prep

Question 1

Nash Equilibrium requires that there are many players

Answer 1

False

Question 2

When asymmetric information is introduced into a game, this typically

Answer 2

changes the strategy set and changes the outcome of the game

Question 3

Cognitive biases help us understand why CEOs: A) Make errors that are entirely specific to the firm, B) Make systematic decision making errors, C) Make random decision making errors

Answer 3

B. Make systematic decision making errors

Question 4

In a game, the number of subgame perfect equilibria will always be higher than the number of Nash equilibria

Answer 4

False

Question 5

In a classical decision theory, decision-makers have unstable, preferences, limited attentional and computational capacities, and their behaviors are driven by expectation of consequences

Answer 5

False

Question 6

Loss aversion means that A) we pay more attention to nonrecoverable costs (and potential losses) when considering future actions, B) We feel losses more acutely than gains of the same amount, C) We root our thinking in an initial value and, fearing loss, we fail to sufficiently adjust our thinking away from that value

Answer 6

B) We feel losses more acutely than gains of the same amount

Question 7

Excessive optimism and overconfidence are examples of stability biases:

Answer 7

False

Question 8

When we seek to find the subgame perfect equilibrium of a game, we A) Start at the bottom of the extensive from game and solve by means of backward induction, B) Start at the top of the extensive form game and solve by means of forward deduction, C) Add players to the game

Answer 8

A) Start at the bottom of the extensive from game and solve by means of backward induction

Question 9

Cognitive biases are always problematic (i.e., reduce value creation) to firms

Answer 9

False

Question 10

In game theory, “strategies” are those actions of a player that are not conditioned on what others do:

Answer 10

False

Question 11

The first Welfare theorem says that any efficient allocation can be decentralized as a competitive equilibrium

Answer 11

False

Question 12

In the world described by the First Welfare theorem, there are no cooperation problems bu there may be coordination problems

Answer 12

False

Question 13

Cognitive biases may be a source of bargainin costs

Answer 13

True

Question 14

The Coase theorem assumes that: A) Transaction costs are zero, B) Transaction costs are zero and there are no wealth effects, C) The sub-game perfect equilibrium will always be optimal

Answer 14

B) Transaction costs are zero and there are no wealth effects

Question 15

The first welfare theorem and the coase theorem: A) Describe realistic theoretical ideals, B) Present imaginary worlds in which markets don’t exist, C) Describe the conditions under which first best efficient outcomes can be reached

Answer 15

C) Describe the conditions under which first best efficient outcomes can be reached

Question 16

A key implication of the Coase theorem is that the more complete a contract, the further away we get from efficiency (all else equal)

Answer 16

False

Question 17

The Coase Theorem implies that the closer we get to full information, the closer we get to efficiency (all else equal)

Answer 17

True

Question 18

When transaction costs are really high, firms are highly flexible

Answer 18

False

Question 19

When there are transaction costs and welath effects, efficiency has no meaning

Answer 19

False

Question 20

Firms cannot use the price mechanism inside their hierachies, as prices onlu make sense in a market

Answer 20

False

Question 21

The basic ingredients of the agency problem are: A) Incomplete contracts, opportunism, and asset specificity, B) A surplus, asymmetric information, and conflicts of interest, C) A principal, an agent, and a conflict

Answer 21

B) A surplus, asymmetric information, and conflicts of interes

Question 22

The agency problem describes a sitution where the Coase theorem doesn’t hold

Answer 22

True

Question 23

In agency theory, contracting is such that the parties can perfectly observe each others’ actions

Answer 23

False

Question 24

In agency theory, monitoring and incentives are alternative

Answer 24

True, False

Question 25

The efficient agency contract A) Meets the participation constraint, B) Has zero welath effects, C) Meets the participation and the incentive constraints

Answer 25

C) Meets the participation and the incentive constraints

Question 26

A high beta in the wage equation should be adopted A) When agents are low in risk aversion and their efforts are highly responsive to incentives, B) When the signal on the agent’s effort (z) is very noisy, C) When the relation between the production result and the agent’s effort is rather ambigious and the agents only engages in one or only a few tasks

Answer 26

A) When agents are low in risk aversion and their efforts are highly responsive to incentives

Question 27

A low beta in the wage equation means that the firms are more likely to recruit high-performers

Answer 27

False

Question 28

Adopting a high-powered incentive system (high beta) means that the management need to care less about rewards

Answer 28

True, False

Question 29

The tradeoff between incentives and insurance can be influenced by, e.g., management info systems

Answer 29

True

Question 30

Firms that delegate more will have more agency problems

Answer 30

True

Question 31

An agent’s utility of W depends on var (W), even if E (W) stays constant

Answer 31

True

Question 32

Lazear’s analysis suggests that firms should in general adopt pay-for-performance

Answer 32

False

Question 33

Jensen & Murphy’s findings suggests that firms should in general adopt pay-for performance

Answer 33

Fasle

Question 34

Jensen & Murphy’s findinds suggest that the agency problem in US corporate governance is small

Answer 34

False

Question 35

In Lazear’s analysis of incentives, Var (output/employee) was reduced

Answer 35

False

Question 36

A low beta in the wage equation make sense when A) Employees work independently, B) jobs involve a low level of multitasking, C) Individual productivities are difficult to measure

Answer 36

C) Individual productivities are difficult to measure

Question 37

In Safelite glass, the increase in beta led to less employee sorting in and out of the firm

Answer 37

True

Question 38

According to Jensen and Murphy, the link between CEO pay and shareholder wealth is weak because, A) CEOs are risk-averse, B) The public dislikes high CEO pay, C) Boards are very good at (input-)monitoring CEOs so that they don’t need to tie pay and firm performance together

Answer 38

B) The public dislikes high CEO pay

Question 39

In agency theory, the contracting problem is that the principal fails to anticipate certain contingencies

Answer 39

False (the P anticipates all possible contingencies but does not what exactly the agent did and the realization fo the random vairable)

Question 40

Inefficiency in a PA relationa rises because A) The parties face asymmetric information, B) Becuse of teh agent’s risk aversion, C) Because it is not possible at the same time to make the agent pick the efficient action and efficiently share risk between P and A

Answer 40

C) Because it is not possible at the same time to make the agent pick the efficient action and efficiently share risk between P and A

Question 41

In Jensen & Murphy’s analysis, relatively low executive pay is partly compensated by a high risk of dismissal:

Answer 41

False

Question 42

In the agency problem, the risk premium A) Is a cost that emerges because of different risk preferences and asymmetric information, B) compensates the agent for the loss in utility he suffers when Var (W) increases, C) varies positively with beta, D) A and B, E) B and C, F) A, B and C

Answer 42

F) A, B and C

Question 43

Jensen and Murphy demonstrates that when the beta faced by executives increases, this causes a gain to shareholders

Answer 43

False

Question 44

In agency theory, it is costless to write a contract

Answer 44

True

Question 45

Employees generally prefer piece rates because this pay arrangement increases their income

Answer 45

False

Question 46

Two employes handle 6 activities which consume the same amount of time and which differ in measurability. All else being equal, the activities should be allocated such that: A) Employee A handle those activities that are most easy to measure, while Employee B handles those activities that are most difficult to measure, B) In this situation, the activity mix across the employees doesn’t matter, C) Employee A handle one easy-to-measure, while Employee B handles two of these, and the difficult-to-measure activities are then allocated with two to and one to B, D)The best approach is to randomize the allocation of activities for reasons of risk allocation

Answer 46

A) Employee A handle those activities that are most easy to measure, while Employee B handles those activities that are most difficult to measure

Question 47

When there are no problems of misaligned incentives (moral hazard), all frictions that may impede exchange are absent, and then actors will immediately reach value-maximizing (“first-best”) outcomes

Answer 47

False

Question 48

Jim Smith is a taxi driver in New York City. He works for the Big Yellow Taxi Company. On average he can generate $100 of net revenue (after fuel costs, etc.) by working in his cab for one hour (i.e., 100h, where h is any given number of hours). His personal cost of effort is 10h2, where h is the hours worked in the cab during the day. Both Jim and the owners of the taxi company are risk neutral. Jim’s outside opportunities require that he be paid average compensation of at least $50/day plus his personal costs of effort.
The numbers of hours worked per day that maximize the expected surplus from hiring Jim are:
A. 8 hrs.
B. 5 hrs.
C. 7 hrs

Answer 48

B. 5 hrs. Differentiate 100h-10h2 and set equal to 0; then h = 5).

Question 49

Delegation is likely to lead to increase of beta in the linear wage equation

Answer 49

True

Question 50

When information is symmetric, delegation increases the agency problem

Answer 50

False

Question 51

Optimal delegation A) equalie the toal costs and benefits of delgation, B) equalizes the marginal costs and benefits of delegation, C) Means that all local knowledge in the firm is exploited

Answer 51

B) equalizes the marginal costs and benefits of delegatio

Question 52

The more specialized job functions are, the more delegation

Answer 52

False

Question 53

Firms in fast-moving industries are likely to have a higher level of delegation

Answer 53

True

Question 54

Delegation may itself reduce agency costs

Answer 54

True

Question 55

Making optimal use of local knowledge that is dispersed in the organization requires state-of-the-art knowledge management systems

Answer 55

False

Question 56

Markets and firms are different because
A. Firms make use of relatively high-powered incentives, markets of relatively low-powered incentives.
B. In markets, unlike firms, all property rights are fully delegated.
C. In markets, individuals are owners, whereas decision rights to corporate resources are only “on loan.”

Answer 56

C. In markets, individuals are owners, whereas decision rights to corporate resources are only “on loan.”

Question 57

Based on agency theory, we would preduct a high level of delegation and a low level of risk aversion of employees are correlated

Answer 57

True

Question 58

Digital tools such as big data, predictive analytics, and AI will lead to more delegation in firms

Answer 58

False

Question 59

U-form hierarchies are likely to exhibit more instances of confirmation bias than project matrix form hierarchies, all else equal

Answer 59

True

Question 60

u_form hierarchies are preferable to M-form hierarchies from an agency theory perspective

Answer 60

False

Question 61

A potential incentive cost of delayered hierarchy is that promotion opportunities are removed

Answer 61

True

Question 62

For a fixed number of workers, when the span of control is increased, the number of layers in the hierarchy A) is reduced, B) is increased, C) doesn’t change

Answer 62

A) is reduced

Question 63

A narrow span of control
A) means that managers are likely to be more familiar with employees
B) are less capable of providing immediate feedback

Answer 63

A) means that managers are likely to be more familiar with employees

Question 64

Mintzberg’s “simple strucutre” is the same as the “simple hierarchy”

Answer 64

True

Question 65

Self-organizing teams always beat hierarchies in terms of flexibility

Answer 65

False

Question 66

As uncertainty increases, firms will make more use of
A) standard operating procedures
B) planning
C) Targets and goals and let it be up to employees how they meet these

Answer 66

C) Targets and goals and let it be up to employees how they meet these

Question 67

We would expect the use of performance-based rewards to be associated with the use of targets and goals

Answer 67

True

Question 68

Delayering may mean that employees become less empowered

Answer 68

False

Question 69

A transaction which is high in uncertainty and frequency, but low in asset specificity is best handled by hierachy

Answer 69

False

Question 70

Transactions that require coordinated adaptation are best handled by markets

Answer 70

False

Question 71

Moral hazard and opportunism both refer to ex post situations (after signing a contract)

Answer 71

True

Question 72

Delta airlines made a smart move by purchasing the Philadelphia oil refinery, because they would then have lower costs than other airlines if the price of fuel went up

Answer 72

False

Question 73

Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for the firm

Answer 73

False

Question 74

One advantage of a hybrid form is that it can achieve some of the advantages of hierarchies (such as a good flow of information), while avoiding the costs of managing dissimilar capabilities in the same firm

Answer 74

True

Question 75

TCE suggests that people are generally opportunists

Answer 75

False

Question 76

According to TCE, if it wasn’t for opportunism, there wouldn’t be any contractual problems

Answer 76

True

Question 77

Hybrid forms are particularly stable in the face of disturbances

Answer 77

False

Question 78

Internalizing a transaction eliminates the transaction costs associated with the transaction

Answer 78

False

Question 79

Outlets that are located closely to the franchisor are more likely to be franchise-operations

Answer 79

False

Question 80

Hybrids may be classified on the basis of how close to/far from they are from marekts or hierarchies

Answer 80

True (think of the “pure” market and the “pure” hierarchy as defining end pts on a spectrum; we can then distribute the various froms on this spectrum)

Question 81

Wholly-owned outlets have stronger incentives to reduce product quality than franchise owned outlets

Answer 81

False

Question 82

As conglomerates are not based on shared resources, they make zero economic sense

Answer 82

False

Question 83

In general, as a franchisor you should exploit your bargaining power to the max

Answer 83

False

Question 84

Relatively less use will be made of markets and hybrids and relatively more will be made of vertical integration in developing countries

Answer 84

True (there are likely to be more problems of enforcing contracts in such countries)

Question 85

Making the franchise a residual claimant eliminates his incentives to moral hazard

Answer 85

False (reduces, but doesn’t eliminate the incentives; there are still incentives to free-ride on the brand)

Question 86

An expansion of the horizontal boundaries of the firm in the form of a diversification move is best organized by a M-form hierarchy

Answer 86

True (this keep complexity low)

Question 87

Firms with a high degree of unrelatedness in the product portfolio are likely to have many complex interdependencies

Answer 87

False

Question 88

Adding a new business to a conglomerate form will be more costly than adding a new business to a related diversifier

Answer 88

False

Question 89

The firm’s owners are the shareholders

Answer 89

False

Question 90

The costs of ownership are
A) Monitoring costs, risk-bearing, and costs of collective decision-making
B) Monitoring costs, costs of collective decision making, and contractual lock-in costs
C) Risk-bearing, hold-up costs, and cost of collective decision making

Answer 90

A) Monitoring costs, risk-bearing, and costs of collective decision-makin

Question 91

Because the members of Lego’s open innovation communities make relation-specific investments when they offer suggestions for how to improve Lego product, etc., they should have an ownership stake in Lego

Answer 91

False

Question 92

In the property rights approach, the boss has authority over a worker because he can deprive him of the assets he works with

Answer 92

True

Question 93

In the property rights approach, the investment level depends on the governance structure

Answer 93

True

Question 94

If in a relation a party is asked to make a specific investment, some way should be found to strengthen that party’s bargaining power

Answer 94

True

Question 95

Integrating two parties will usually strengthen the incentives of bot parties to make relation-specific investments

Answer 95

False

Question 96

If two parties in a relation both make specific invesrtments, and one of the parties makes investments that have small implications for value creation, this party should assume ownership of the asset

Answer 96

False

Question 97

All firm ownership arrangements may be analyzed as cooperatives

Answer 97

True

Question 98

In banks, loan officers increasingly make customized rather than vanilla loans. This is likely to give them less bargaining power

Answer 98

False (making customized loans means that you are getting bargaining power because you get more control over key customer relationships)

Question 99

What is loss aversion?

Answer 99

A bias in the category: Framing of alternatives. Means that losses are felt more acutely than gains of the same amount

Question 100

What is escalation of commitment?

Answer 100

A bias in the category: Framing of alternatives. Investing additional resources in an apparently losing proposition b/c of what we already invested

Question 101

What is Confirmation bias?

Answer 101

place too much weight on evidence consistent with favored belief

Question 102

What is groupthink?

Answer 102

Conformity-seeking makes us disregard alternatives

Question 103

Knowledge bias?

Answer 103

We assume others know what we do

Question 104

What does excessive optimism mean?

Answer 104

Means that we overestimate p (positive events), underestimate p(negative events) (action-oriented bias)

Question 105

What does self-serving bias cover?

Answer 105

We overestimate our skill level relative to others, how much we contributed to joint efforts and out contribution to positive outcomes

Question 106

What is status quo bias?

Answer 106

Prefer things (etc) in their current state

Question 107

What is present bias?

Answer 107

We value immediate rewards very highly, undervalue long-term gains

Question 108

What does endowment effect mean?

Answer 108

We ascribe more value to things when we own them

Question 109

Orange picking exercise: Why pay per tree (instead of, say, a flat wage)?

Answer 109

Possible answer: High-powered incentive that reduce the need to observe/monitor individual agents

Question 110

Orange picking exercise: Why pay the team (rather than the individual)?

Answer 110

Possible answer: Less expensive to observe team output than individual output

Question 111

Orange pricking exercise: Why let the team distribute the rewards?

Answer 111

Possible answer: Team-members can better observe individual productivity than a manager is capable of. They can motivate each other by varying pay

Question 112

Orange picking exercise: Would fruit pickers prefer this mode of organization (team-based pay-per-tree reward)?

Answer 112

Possible answer: Probably; it saves on the costs of solving motivation problems. The savings may be shared between the team and the owner

Question 113

1st Welfare theorem:

If x, y, z … then the resulting allocation of goods and services is Pareto optimal

Answer 113

1: each firm maximises its profits; knowing the prices and its own production technology

2: each consumer maximises utility; knowing the prices and his own preferences

3: income and prices are such that demand equals supply for every good and service

Question 114

In an agency relation, moral hazard results when … ?

Answer 114

1) the agent can engage in post-contractual behavior that affects the utility of both principal and agent (externality)

2) the principal can only observe an imperfect signal of the agent’s effort (usually the outcome - not the actual effort exerted! (control problem)

3) the action the agent will take spontaneously is not opitmal (inefficiency)

Question 115

What is the agent’s wage equation?

Answer 115

W=W0+beta(e+theta)

Question 116

What did Lazear’s study show?

Answer 116

Implemeted piece rate:

Output per worker incresed dramatically

Firm-level output increased

Profits and wages increased

Var (ouput/worker) increased (more able/ambitious workers increased their output more)

Able/ambitious workers selected into the firm (“sorting”) (average ability increased)

Question 117

Centralized firm good at (accepting/rejecting) projects

Answer 117

rejecting projects but will also reject more good projects

Question 118

Decentralized firm good at (accepting/rejecting) projects?

Answer 118

accepting projects but will also accept more bad projects

Question 119

What are the benefits & costs of delegation?

Answer 119

Benefits:
- Economiing with managerial time
- Speedy decision making
-Motivation
- Utilizing “local” (tacit” knowledge

Costs:
- Agency costs

Question 120

What are the advantages of a narrow span of control?

Answer 120

• Higher degree of control
• Manager is more familiar with individuals
• Close supervision can provide immediate feedback

Question 121

What are the disadvantages of a narrow span of control

Answer 121

• More management levels, more expensive
• Slower decision making
• Isolation of top management
• Discourages employee autonomy

Question 122

What are the advantages of a wide span of control?

Answer 122

• Increased efficiency and reduced costs
• Quicker decision making
• Greater flexibility

Question 123

What are the disadvantages of a wide span of control?

Answer 123

• Less control
• Possible lack of familiarity
• Managers spread thin
• Lack of coordination

Question 124

What are the advantages of “Simple hierarchy”?

Answer 124

.- Clear view of organizational goals
- Wide spans of control and centralized authority allow quick decision making
- Little formalization ensures flexibility

Question 125

What are the disdvantages of simple hierarchy?

Answer 125

• Often unfeasible for larger organizations with high variety/complexity of tasks
• Depends critically on the CEO

Question 126

What are the advantages of a functional structure?

Answer 126

• Efficiencies from putting together similar specialties and people with common knowledge, skills and orientations
• In-depth specialization
• Coordination within function

Question 127

What are the disadvantages of a functional structure?

Answer 127

• Risk of poor communication
• Limited view of organizational goals
• Siloing

Question 128

What are the advantages of a divisional structure?

Answer 128

• Allows specialization in particular products, services, geographies
• Closer to customers
  Facilitates cross-functional collaboration
• in-built accountability

Question 129

What are the disadvantages of a divisional structure?

Answer 129

• Duplication of functions
• Limits learning/knowledge sharing in functional areas
• Can create unwanted rivalry between divisions

Question 130

What are the advantages of matrix?

Answer 130

• Fluid design that can respond to environmental changes
• High information carrying capacity
  High degree of coordination

Question 131

What are the disadvantages of matrix?

Answer 131

• Expensive and complex
• Dual authority can lead to task and personality conflicts and slow down decision making

Question 132

Examples of firms with pooled interdependencies in their internal organization?

Answer 132

Fastfood chains, much of what Amazon does, some consulting firms, teaching activities in universities, Safelite glass; M-form firms

Question 133

Examples of firms with sequential interdependencies in their internal organization

Answer 133

Car-producers and other firms that make use of assembly lines, U-firms often have a linear activity flow between units

Question 134

Examples of firms with reciprocal interdependencies in their internal organization?

Answer 134

Project-based professional service firms; many research activities in universities, oticon spaghetti

Question 135

How do you expect the reward systems be shaped by the prevailing interdependencies? Pooled

Answer 135

Individual-level incentives often feasible (e.g., consulting, franchising); unit-level incentives (M-form firm). beta can often be high

Question 136

How do you expect the reward systems be shaped by the prevailing interdependencies?Sequential

Answer 136

Hard to measure individual contributions (think workers along an assembly line) beta likely to be low (even 0)

Question 137

How do you expect the reward systems be shaped by the prevailing interdependencies? Reciprocal

Answer 137

unit-level incentives (particularly if units are small, so easy to engage in peer monitoring). Beta can be relatively high

Question 138

Place:

-Hierarchy
- Rules/programs/standard operating procedures
- Targets and goals (employees choose behavior)
possibly supplemented with: slack resources, self-contained tasks, info systems, lateral relations

on a scale from low uncertainty to high uncertainty

Answer 138

From high to low uncertainty:

• Targets and goals (employees choose behavior)
  possibly supplemented with: slack resources, self-contained tasks, info systems, lateral relations

-Hierarchy

• Rules/programs/standard operating procedures

Question 139

What are the core transaction cost economics ideas?

Answer 139

Ppl are bounded rational

2) Ppl are not always trustworthy/honest, but opportunistic

3) Transactions differ with respect to how frequently they take place; the uncertainty that surrounds them; and the degree of asset specificity they involve

4) Different contractual, organizational arrangements (i.e., governance structures) necessary for handling different transactions

Question 140

Quasi surplus is …

Answer 140

… the difference between the value of the asset in the current (best) use and its next best use

Question 141

low asset specifity: (generally Market, Hierarchy or Hybrid?)

Medium AS: (generally Market, Hierarchy or Hybrid?)

High AS: (generally Market, Hierarchy or Hybrid?

Answer 141

Low AS: Market
Medium AS: Hybrid
High AS: Hierarchy

Question 142

Who says that excess resources deployed within firms, resulting in expansion (diversification), when market contracting is not feasible?

Answer 142

Teece. So diversification is a result of market failure

Question 143

Who says that learning and routinization frees resources, which the firm has strong incentive to deploy to diversifiaction

Answer 143

Penrose

Question 144

What are the two hypothesis set forth in Zhou’s article on the consequences for diversification?

Answer 144

H1: Firms with high complexity in their existing business lines are less likely to engage in new diversification moves

H2: This effect is reinforced when the new business shares more inputs with the existing business lines (as complexity is further increased)

i.e., the more the primary and target industries share inputs, the higher the p (diversification move); complexity is negatively associated with the p (diversification move); input similarity magnifies the negative relation between complexity and the p (diversification move)

Question 145

Tit-for-tat strategy

Answer 145

Start playing nicely; subsequently choose the same action that the other player just took

Question 146

The grim strategy

Answer 146

Start playing nice; continue to do as long as the other player plays nice. If he does not play nice, reciprocate with playing bad all the time

Question 147

What are the advantages of self-enforcing contracts?

Answer 147

1) Save on transaction costs, contract drafting costs. Costs of using a third-party enforcement

2) Allows for contracting when third-party enforcement is not possible

3) Allows for more flexibility

4) Sometimes more incompleteness is better than less .. see slide

Question 148

The blockchain and transaction costs: Impact on ex ante transaction costs:

Answer 148

1) reduces costs of assessing trusthworthiness of transaction partners; willingness to commit to the blockchain itself a signal

2) Potential huge set-up costs

Question 149

The blockchain and transaction costs: Impact on ex post transaction costs:

Answer 149

1) Reduces costs of monitoring
2) Reduces costs of dispute resolution (everything is transparent)

Question 150

The blockchain and transaction costs: Impact on ex post transaction costs:

Answer 150

1) Reduces costs of monitoring
2) Reduces costs of dispute resolution (everything is transparent)

Question 151

The blockchain and transaction costs: Impact on ex post transaction costs:

Answer 151

1) Reduces costs of monitoring
2) Reduces costs of dispute resolution (everything is transparent)

Question 151

The blockchain and transaction costs: Impact on ex post transaction costs:

Answer 151

1) Reduces costs of monitoring
2) Reduces costs of dispute resolution (everything is transparent)

Question 152

The blockchain and transaction costs: Impact on ex post transaction costs:

Answer 152

1) Reduces costs of monitoring
2) Reduces costs of dispute resolution (everything is transparent)

Question 153

Business people often argue that firms should make rather than buy inputs to production in order to avoid paying unnecessary profits to suppliers (the “keep profits to yourself” motive). This line of thinking is likely to be:

A) Sound
B) Misguided

Answer 153

Misguided is correct. It is true that sometimes accounting profits (revenues – expenses) can be earned from backward integration (i.e., make). However, this does not necessarily mean that economic profits (accounting profits from preferred activity minus accounting profits from investing the same resources in the best alternative activity) are increased by integration. Second, perhaps suppliers makes high profits; however, this may be because they rely on very scarce skills and expertise that cannot be replicated by the downstream firm. Or, if it seeks to acquire the upstream supplier, it may have to pay a price that reflects the relevant profits. It may be better off paying the “high” price charged by the suppliers. Third, TCE suggests that vertical integration is “the option of last resort.” Making use of high-powered market incentives means that production costs can be kept down.

Question 154

QUESTION 2 of 7: Acme Corp is a medium-sized multinational firm with approximately 1,500 employees and four main business areas (software for online gaming, lead mining, facility services, and accounting services). Acme is now in the process of redesigning its reward systems. Acme management’s thinking about how to reward individual employees starts from the linear wage equation (W =  +  ( e + x + y)), but in addition to considering the size of  + , Acme also wants to include a variable, “y”, which it interprets as the average effort of all other employees than the focal employee. In other words, a given employee is to be rewarded partly depending on the average effort of all his or her colleagues ( is a parameter that indicates the weight of y). Given Acme’s characteristics, this approach is likely to be
A. Sound
B. Misguided

Answer 154

Answer: B is correct. Acme is trying to introduce comparative performance assessment in their reward systems. They specifically think of y as the average effort of all other employees than the focal employee. Agency theory suggests that doing this makes sense if including this measure improves Acme’s estimate of the effort of a given employee. Supposing that Acme cannot exactly observe the effort of an employee but only a signal, z, will adding y (i.e., z +y) improve Acme’s estimate? (Technically, this is the case if Var (z +  y) < Var (z)  Cov (z,  y) > 0). This is likely to be the case if the efforts of employees are impacted by randomness/noise in a similar way (e.g., all salespeople are hit in the same way by a change in demand); then noise can be “filtered out”, when the employers are evaluated and comparisons across employees are used to assist the evaluation. The problem is that Acme is essentially a (small) conglomerate. They are active in very different business areas. The problem is that because of this, a measure of average effort is likely to pick up randomness that is specific to each individual business area. Therefore, using the average effort across the company in evalution is likely to make the evaluation of any given employee highly noisy, i.e., it imposes additional risk on the employee

Question 155

Tube is a major Canadian company in the dynamic online computer games industry. Tube offers its games on its platform Fire. Tube is a medium sized firm with 232 employees, mostly software developers and engineers. Developing a game typically begins from defining the development work in terms of big “chunks” of code and integrating these chunks when the development work has been done. The finished software product is then launched directly on Fire. Tube is best served by a
A. Professional bureaucracy.
B. Simple structure.
C. Adhocracy.
D. Machine bureaucracy.
E. Divisionalized form

Answer 155

Tube is likely best served by an adhocracy which according to the Mintzberg article in the readings engages sophisticated specialists and requires them to combine their efforts in project teams coordinated by mutual adjustment and directed towards an innovative output that is launched in dynamic environment (e.g., a new computer game). This is most likely exactly what goes on in Tube (the wording suggests that software “chunks” are handled by parallel project teams). All other forms differ in various ways from Tube (e.g., professional bureaucracies do not typically make use of mutual adjustment and their specialists work independently; divisionalized forms have highly separate units; the machine bureaucracy is very heavy on the admin side and is typically the form assumed by traditional industrial companies; etc.).
The sophisticated answer may also raise issue such as whether the launching of new games is done by a separate unit or done directly by projects once the development work is done and how this could complicate the answer.

Question 156

Stack ranking is a human resource management practice which involves ranking all employees according to their performance. Often this takes the form of forcing managers to regularly rank employees on a bell curve (normal distribution) of productivity and fire those employees on the segments of the curve furthest to the left. Popularized by Jack Welch at General Electric in the 1980s, stack ranking has been implemented by companies such as Yahoo and Amazon. It has, however, increasingly fallen out of favor among companies. The reasons arguably are these:
A. Stack ranking is destructive for workplace morale, helping behaviors, and may imply high costs of hiring employees.
B. While stack ranking may to some extent increase average employee productivity, it is also likely to be associated with high agency costs.
C. Both A and B.

Answer 156

C) is correct. It is intuitive that stack ranking is likely to be “is destructive for workplace morale, helping behaviors, and may imply high costs of hiring employees” as a key purpose of stack ranking is to continuously increase aggregate work productivity by increasing competition between employees. Hence, A) must be the case.

However, stack ranking is also likely to be associated with high agency costs (i.e., B is also the case). Part of agency costs are the costs of monitoring agents’ actions and learning their abilities which is relevant in the context of hiring new employees (reference to turnover and sorting is warranted here, cf. the Lazear article in the readings).

Stack ranking presupposes monitoring of agents. Placing agents/employees along a curve of productivity may imply precise monitoring of their productivities. Such objective performance assessment is likely to be costly. If it is not possible to precisely monitor productivity, subjective performance assessment will take place which is costly in terms of managerial monitoring effort. Also, employees may perceive such assessment as noisy and as therefore associated with higher perceived risk. They may require a risk premium to compensate them.

To the extent that management in a firm with a stack ranking system still wants employees to, e.g., engage in helping behaviors, it is likely to incur substantial agency costs from trying to call forth and monitor such behaviors (which happen more “naturally” in a less competitive system).

The well-known fact that the distribution of performance is typically not normally distributed may also be mentioned as a problem associated with stacking (one that is particularly important for understanding the incentives of high-performers).

In sum, C) is the correct answer.

Question 157

The German company Acme Messgeräte produces highly advanced, unique, and specialized measurement instruments for use in the chemical industry. Acme distributes the instruments through independent sales agents that distribute the instruments on specified geographical markets. The agents work under identical economic terms. Specifically, according to their contracts with Acme each agent must sell 10 units of each instrument at a price of 200,000 Euros. The per unit price at which the agents purchase the instruments from Acme is 100,000 Euros. Each agent sells exactly 10 units per year, pays 500,000 Euros in yearly rent for the use of classy showrooms and office space, and make a yearly investment of 100,000 Euros in making the showrooms highly specific so as to best showcase Acme’s instruments. Each agent also makes a yearly investment of 300,000 Euros in training their employees in the proper use of Acme’s instruments so that they can better demonstrate the use of the instruments to prospective buyers.
Acme consider raising the price on their instruments. Given the above description
A. The quasi-surplus/rent in the relation is 100,000 Euros/agent and the price per instrument at which an agent is indifferent between buying from Acme and quitting the relation is 110, 000 Euros.
B. The quasi-surplus/rent in the relation is 300,000 Euros/agent and the price per instrument at which an agent is indifferent between buying from Acme and quitting the relation is 150, 000 Euros.
C. The quasi-surplus/rent in the relation is 400,000 Euros/agent and the price per instrument at which an agent is indifferent between buying from Acme and quitting the relation is 120, 000 Euros.
D. The quasi-surplus/rent in the relation is 500,000 Euros/agent and the price per instrument at which an agent is indifferent between buying from Acme and quitting the relation is 150, 000 Euros.

Answer 157

D) is correct. It is clear from the wording that the relation between Acme and its agents is one that is currently ongoing (“the agents work” etc.). In other words, investments have been made, and Acme may be seen as contemplating how it can leverage its bargaining power in the relation to its own advantage. The quasi-surplus is the value that the party possessing bargaining power in a (bilateral) relation can appropriate and still leave the other party indifferent between leaving or staying in the relation. In this case the quasi-surplus is 500,000 Euros/agent. This corresponds to Acme raising the price from 100, 000 to 150,000 Euros for each measurement instrument (50,000 Euros for each of the 10 instruments = 500, 000 Euros). Acme earns 1,000, 000 / agent, but an agent only quits s/he pays 1,500, 000. This is the simply way to conclude that the quasi-surplus must be 500, 000 Euros.
Alternatively, suppose that it costs an agents x to buy the 10 instruments from Acme. There are two alternatives: A, stay in the relation, and B, quit the relation.
A: An agent’s situation if s/he stays in the relation is: 2,000, 000 – (x + 500,000 + 400,000) = 1,100,000 – x
B: An agent quits when all of the sunk costs is appropriated (plus a tiny bit more), i.e., when the 400, 000 is appropriated by Acme.
I.e., the agent will quite the relation when 1, 100, 000 – x < -400,000  x > 1,500, 000
In other words, the Acme can appropriate (up to) the sunk costs plus the profits (500, 000) which at a price per instrument of 150,000 leaves each agent just indifferent between quitting and staying.