Problem Set 1, Fall 1996-- Solutions
1. One feature of many labor contracts is work rules. Work rules restrict managers with respect to how to organize production. For example, work rules in a labor contract between railroad engineers and railroads may limit the number of hours per day or week individual engineers can work. One implication of such a provision would be that the engineer could not work additional hours, even in individual cases where both the railroad and the engineer (perhaps because they are being paid above their normal wage for the extra hours) would be better off if they could do so.
Assume that we are considering only the interests of railroads' shareholders and employees (white and blue collar workers). Assuming no wealth effects or transaction costs, is a limitation of engineers' hours likely to be part of an efficient institutional structure? Why or why not?
Such a limitation is not likely to be part of an efficient institutional structure. The problem implies that such rules would prohibit voluntary agreements between individuals which would make each shareholder and employee at least as well off, and some better off. Therefore, an institutional structure which included work rules could not be efficient.
Sometimes laws, rather than negotiated work rules, put limits on employees' hours. Is there an efficiency explanation for such laws with respect to railroad engineers?
This was a very tough question. The point of the question was to show that whether an arrangement is efficient depends on whose interests count.
Above we were only considering the interests of railroads' shareholders and employees -- not those of other individuals such as their customers. An agreement between the railroad and its engineers which let the engineers work extremely long hours may affect the utility of other individuals. Tired engineers may be more accident-prone.
If it were not costly for consumers to become fully-informed about the railroad's safety and bargaining costs were zero, this would not be a problem. There would be no externality because the price of travel would fully account for the safety of the railroad. (Under no wealth effects and no transaction costs, the Coase Theorem applies.)
But because these costs exist, decisions made internally by the railroad may affect consumers' utility. Choices which are efficient when considering only the railroad's shareholders' and employees' interests may not be when considering those of their customers (or non-customers who may be affected adversely by increases in train accidents). Making such a law may lead to decisions which result in higher total value if the increase in consumers' utility from such decisions is greater than the decrease in the utility of those inside the railroad.
Further comment after reviewing the class' answers: Some of you claimed that work rules might be efficient to prevent railroads from overworking engineers, or to prevent engineers from "overworking" themselves. This is incorrect, assuming that parties are able to enter into transactions voluntarily and make their decisions rationally. In the problem, we are also assuming no transactions costs -- which means among other things that all economic agents are able to know the effects of their actions.. "Preventing engineers from overworking" implies that engineers are not acting rationally. We generally assume that people act (at least boundedly) rationally because once you relax rationality, you can explain anything. "Preventing railroads from overworking engineers" implies that engineers -- at the time they agree to a contract with railroads -- are unable to foresee that there may be circumstances where a) railroads would ask them to work more, and b) it would be engineers' self-interest at that point to do so.
In general, claiming that paternalism has efficiency justifications is difficult. To justify governmental intervention, one usually has to appeal to transactions costs. (This is one of the many lessons of the Coase theorem.) These explanations encompass "certain parties have imperfect information" because one form of transaction costs are the costs of acquiring information. They also encompass "it is less costly to set one rule for every circumstances than determine contractual terms on a case-by-case basis" for obvious reasons.
2. Economic consulting firms often have two tiers of senior economists: for simplicity, I will refer to them as project leaders and staff economists. Project leaders recruit clients (usually law firms, in this case) and are in charge of any case for which they are hired. They generally cultivate clients and complete their work with little supervision or direction from upper level management. Clients are billed by the firm. The project leader receives a relatively high percentage of the revenues the firm receives from the clients they bring in. Their billing rate is often well over $100 per hour, sometimes more. Staff economists work on cases under the direction of project leaders; their billing rate is substantially lower than project leaders.
Using the criteria proposed by Coase, should economic consulting firms be viewed as single firms, or separate firms? Using this criteria, do upper-level managers, project leaders, and staff economists all work for the same firm? Explain.
I accept either "single" or "separate" as long as a good argument is made.
Staff economists clearly work for the same firm as product leaders. The only issue is whether transactions between upper-level management and project leaders are coordinated via the price mechanism or by fiat. The question implies that upper-level management exercises little (but not no) direction. This is the main piece of evidence that they work for the same firm. The level of the pay project leaders receive is irrelevant. The fact that they are paid a function of the work they bill does not limit upper-level management's ultimate discretion -- this is the main piece of evidence if you want to claim that they are separate firms.
3. According to Alchian and Demsetz, why are managers residual claimants rather than workers? Are managers generally residual claimants in real life? If so, in what types of firms? Where this is not the case, what new incentive problem arises?
Managers are residual claimants so that market competition solves the "who monitors the monitor" problem. Making the manager residual claimant means that he or she internalizes the benefits and costs from his or her monitoring. Some real-life managers are residual claimants, some are not. (For example, managers of gas stations are, but managers at UCLA are not.) Managers of small businesses ("mom and pop" stores) are generally residual claimants. Where this is not the case, the "who monitors the monitor" problem arises.
4. Define moral hazard. Why do incomplete contracts often create situations of moral hazard? Provide an example of an institution or organizational feature that arises in response to moral hazard (that is, something that we would do not observe in situations where there are not moral hazard problems).
Moral hazard is post-contractual opportunism; it exists in situations where, because of incomplete contracts, individuals do not internalize the full consequences of their actions.
Any device or organizational features which monitors workers is a feature that arises in response to moral hazard. So are deductibles in insurance contracts. There are many possible answers.
5. One of the trends in business during the past ten years or so is the increasing use of electronic data interchange, or EDI. In electronic data interchange, firms use computer networks or dial up connections to exchange information such as invoices, orders, delivery confirmation. These replace previous processes in which such information was exchanged using phone, fax, or even mail-based systems. One advantage is that they permit the timely exchange of data. Another is that they can be linked to firms' internal computer systems so that individuals do not have to rekey information when it comes in. A drawback is that they often require firms to purchase considerable amounts of new hardware or software, and they can require them to make costly changes to their existing business practices to take full advantage of the new capabilities.
Suppose we are considering whether a specific supplier and manufacturer will adopt this new technology.
What determines whether doing so is efficient relative to their current fax-based system?
Assume that we are considering the welfare (profits) of the two firms, but not each individual at each firm. Then adoption is more efficient if it is part of an arrangement in which both firms are at least as well off, and one is better off, than in the existing system.
Suppose that the manufacturer anticipates that the new system will generate production improvements that will greatly outweigh the cost savings, but that the supplier anticipates that the new system will not "pay for itself." Does this mean that adoption is inefficient? Why or why not?
No, it does not mean that it is inefficient, because the manufacturer may be able to make a side payment to the supplier (subsidize adoption) such that both parties are better off than with the existing system.
Assume that adoption is efficient relative to current systems. Under what set of assumptions is adoption guaranteed to take place, even if the investment does not "pay for itself" for one of the firms?
By the Coase theorem, no wealth effects and zero bargaining costs.
Automobile makers (Ford, GM, Chrysler, et al) have been struggling for the past five to ten years to get their outside suppliers to move to EDI-based systems. Using the ideas presented in class, why would you expect that they would have such a difficult time doing so, assuming that EDI is efficient relative to other systems?
One reason is that, absent side payments, many suppliers' (especially small ones) costs of adopting EDI system outweigh their benefits. In such cases, auto makers have to subsidize adoption through side payments. Negotiating over the size of these side payments is costly. The problem is worsened because suppliers often have private information about their costs and benefits of adopting the new system, and have an incentive to exaggerate their costs to obtain a greater subsidy from Ford.
These bargaining costs may inhibit the adoption of technologies that would increase the productive efficiency of auto makers and their suppliers.