Chapter 6: The Organization of the Firm

Answers to Questions and Problems

1. When an input has well-defined and measurable quality characteristics and requires
specialized investments, the optimal procurement method is a contract. A contract
reduces the likelihood of opportunistic behavior and underinvestment by creating a
legal obligation between the firms. One disadvantage of a contract is that it increases
a firm’s transaction costs. An example, Boeing contracting with an aluminum
manufacturer.

2. When a firm requires a limited number of standardized inputs that are sold by many
firms in the marketplace, the optimal method of procurement is spot exchange. One
advantage of spot exchange is that they permit firms to specialize. A disadvantage is
that the firm may potentially face the hold-up problem. An example, a painter
purchasing paint from a local paint store.

3. a. Contract

b. Vertical integration

c. Spot exchange (or possibly contract if a specific investment in many motors is

required).

d. Spot exchange

4. Engine manufacturing involves specific investments and a complex contracting

environment. By vertically integrating, the potential for opportunism is reduced.
Mirrors are relatively uniform products that can be purchased by spot exchange or
contract.

5. a. Human capital

b. Physical asset specificity; note that the assembly line was designed especially for a
particular firm’s product.

c. Site specificity

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6. The manager will choose 10 hours of leisure under the fixed salary. However, she
prefers the compensation scheme that pays a fixed salary plus a percentage of the
profits. Essentially, the manager is faced with a choice between two consumption
bundles: (1) a $100,000 fixed salary plus 10 hours of on-the-job leisure and (2)
$100,000 in salary plus bonus ($30,000) plus 3 hours of on-the-job leisure. Since the
original compensation package of a $100,000 and 10 hours of shirking is still
available, the fact that she chose to work 7 hours reveals that she prefers the second
pay scheme.

7. Spot checks and hidden video cameras are effective and relatively inexpensive to
implement initially. The disadvantage is that spot checks and hidden video cameras
may affect the morale of the workers. Moreover, implementing hidden cameras
requires more employees to monitor the cameras. The advantage of pay for
performance schemes is that it may be easier for a managers to observe individual
worker (or group) performances. However, pay-for-performance schemes may be
costly. In addition, when output is a function of group performance or its quality is
difficult to measure, an individual’s contribution to the output may not be observable.

8. a. Reduce the benefits of vertical integration.

b. Reduce the benefits of vertical integration and lead firms to use contracts or spot
exchange to procure inputs.

c. Lead to contracts that are more detailed or vertical integration.

d. Make spot exchange an unattractive method of procurement due to opportunism and

possibly underinvestment.

e. Make contracts a less attractive form of input acquisition.

f. Lead to longer contracts, or in extreme instances, vertical integration.

9. a. When MC(L) = 30 + 4L, the optimal contract lengths sets this equal to the marginal
benefit of $100, yielding L = 17.5.

b. When MC(L) = 40 + 5L , the optimal contract length sets this equal to the marginal
benefit of $100, yielding L = 12.

c. When the marginal cost curve increases, the optimal contract length increases. When
the marginal cost curve decreases, the optimal contract length decreases.

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10. a. When the MB = 120, the optimal contract length sets this equal to MC, yielding
L = 20.

b. When the MB = 180, the optimal contract length sets this equal to MC, yielding
L = 32.

d. Increases in the marginal benefit to writing a contract increase the contract length.
Decreases in the marginal benefit to writing a contract decrease the contract length.

11. The environment in which computer manufacturers operate is very uncertain. The rate
of technical progress among chip, and other hardware, manufacturers increases the
marginal cost of signing long-term contracts.

12. A contract decreases the problem of opportunism and still allows the firm to
specialize in production.

13. Capping pension fund managers’ compensations would reduce the executives’
incentives to maximize the value of the fund under their control, thereby reducing the
overall return to the fund participants.

14. Contracts requiring large specialized investments are expected to be longer than
contracts requiring relatively smaller specialized investments. The reason is that
transaction costs increase once the contract expires. By writing longer contracts, these
costs can be avoided. Thus, large specialized investments increase the marginal
benefit of writing longer contracts.

15. The first important point to make with shareholders is that restructuring the incentive
plan is designed to maximize shareholder value. This is achieved by giving
employees incentives to stay with the company longer, thereby reducing costly
employee turnover and increasing the company’s profitability. Also, by restructuring
the incentive plan, employees will want to find ways to work more productively and
make the company more profitable. The benefits to the shareholders and the
employees will be a higher stock price.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
16. The reduction in another supplier’s cost of producing airbags reduces Honda’s
marginal benefit of contracting. Therefore, the 15-year contract that has been
negotiated is too long; the optimal contract length is now less than 15 years.

17. The manager might pay a salesperson a base salary plus a percentage of the profits.
This plan would penalize salespersons, to some extent, for excessive mileage.

18. In the absence of an incentive contract, a manager may still choose to maximize
profits in order to build a reputation in being a superb manager and increasing the
potential of future management opportunities. Furthermore, the threat of a takeover
by other investors and job loss also disciplines managers to maximize profits, even if
they are paid a fixed salary.

19. The transaction between Air Liquide and Yan’an requires significant specialized
investments by Air Liquide, not least of which is the size of the ASUs. If the parties
instead used a spot exchange, Air Liquide would be at significant risk of hold-up by
Yan’an after building the ASUs, since they likely would find it difficult to find an
alternative customer wanting to buy the exact ASUs they build. The fact that the two
firms were able to agree to a long-term contract implies vertical integration is not
desirable. The firms should consider vertical integration when contracting is
particularly difficult, which does not appear to be the case here. Vertical integration
creates a firm that no longer specializes in what it does best – a path that generally
should be avoided if contracting is feasible.

20. The principal-agent problem in this situation exists between on-duty police officers
(the agent) and the city officials who hire them (the principals). On-duty police
officers were supposed to prevent picket lines from blocking worker access. Members
of the police union appear to be engaging in opportunistic behavior to improve their
bargaining power. The city of Boston has committed to spending $14 million to host
the DNC and the police union is attempting to take advantage of this specialized
investment. Therefore, the city of Boston is facing the “hold-up problem” as defined
in the book. The problem also illustrates the problem of writing contracts: when the
city of Boston wrote a contract with Shawmut Design and Construction there were
many unforeseeable events that may not explicitly be defined in the contract.

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21. Business-process outsourcing (BPO) is a contractual relationship with a third-party
firm, whereas a firm that produces human resource services internally is vertically
integrated. Contracting human resource services with a third party allows the firm to
specialize in activities related to its core business, which as the problem points out
may result in large cost savings. Contracts, however, are costly to write and often
incomplete. These reasons provide justification for vertical integration. Contracting
with an international-based firm may be more costly since the contract must be
written in a manner to protect the firm in a foreign country. This extra cost should be
compared to the extra benefit (cost savings) that accrues from lower off shore labor.
Furthermore, there may be cultural difference in hiring practices that may make
outsourcing from human resources to an international firm less attractive.

22. If partners in the law firm are paid an equal share of the overall profits of the firm,
regardless of how much they contribute, lawyers nearing retirement will have an
incentive to stay with the firm while doing as little work as possible. In this way, he
or she can enjoy “semi-retirement,” but will continue to earn a share of the profits
from other’s hard work. For this reason, most law firms have mandatory retirement to
mitigate incentive compatibility problems. Eliminating mandatory retirement is
probably not a good idea for your 30-year old client.

23. The money the dealership pays to train workers in the form of time and expenses is a
specialized investment in human capital. The investment only has value to the
dealership if workers remain with the dealership and the dealership maintains its
relationship ADP. Once this is sunk, it faces a potential “hold-up” problem from
workers and ADP: If either party decides to sever the relationship, the dealership will
have to sink additional funds into training new employees.

24. Andrew had to make sunk investments to use Initech’s products that sum to $2,000.
These consist of the $1,000 in sunk capital investments and the learning time (which
is also sunk) valued at 40 × $25 = $1,000. Since these investments are sunk, and we
know Andrew must make at least this much of an investment to use another product,
Initech can come back and try to “rob” Andrew of his investment by asking for
$5,000 ( = $3,000 + $2,000). Or, to be sure it is strictly better than any alternative,
they may ask for $4,999.

25. The marginal benefit for each year of the contract is $1,000 as stated in the problem.
The total cost of Y years is $100 × L = $100 × Y2. This means the marginal cost of Y
years is $200 × Y. Setting marginal benefit equal to marginal cost gives us Y = 5.

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26. Jim should be willing to pay up to, and no more than, $1,800 in fixed fees to Coke. If
they ask for more, he should reject the offer, switch to Pepsi, and make the $1,800 in
investments to use the Pepsi product instead.

27. The owner’s take before the change was $120,000 - $65,000 = $55,000. After the
change, the owner gets 0.85 × $280,000 - $30,000 = $208,000. So, the change in
compensation for her top manager made her an extra $208,000 - $55,000 = $153,000.
The manager makes more money as well. Before, he earned $65,000, and under the
new compensation scheme, he earns 0.15 × $280,000 + $30,000 = $72,000.

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© 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.