ECON 401, Chapter 6: The Org of the Firm

If a firm manager has a base salary of $50,000 and also gets 2 percent of all profits, how much will his/her income be if revenues are $8,000,000 and profits are $2,000,000?

$90,000

Suppose compensation is given by W = 450,000 + 220 π + 15S, where W = total compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

12.6 percent

Hold-up:

A. is a hazard associated with relationship-specific exchange.

12. Spot markets are an efficient way for the firm to purchase inputs if:

A. opportunism is not a problem.

10. Spot exchange can be inefficient in the presence of:

A. opportunism.

A firm manager is an agent hired by the:

A. owner to control the production process.

5. Long-term contracts become longer:

A. when specialized investment becomes more important.

Which of the following occurs as firm size grows?

Administrative and bureaucratic costs rise at an increasing rate.

14. In the absence of worker incentives:

B. there is a natural tendency for workers to not give their maximum effort.

7. When relationship-specific exchange occurs in complex contractual environments, the best way to purchase inputs is through:

B. vertical integration.

18. Which of the following payment plans does NOT give an incentive to a manager to stop shirking?

C. Flat salary regardless of firm profits

Which of the following is NOT an example of a piece-rate compensation method?

C. Paying a carpenter to install a new back porch

If a manager wishes to produce a large level of output, which compensation mechanism is most effective?

C. Revenue sharing

19. The most likely effect of reducing performance-based rewards for the CEOs of corporations would be:

C. a drop in profits.

If a manager is not the owner, the manager:

C. does not receive the full benefit nor the full cost of his or her decisions.

Under a profit-sharing compensation scheme, the manager will:

C. optimize his choice between income and leisure.

16. A drawback of separating ownership from control by creating a firm is:

C. the principal-agent problem.

A potential problem with piece-rate plans is that:

C. workers may put little emphasis on the quality of the good.

3. Which of the following is NOT an incentive scheme to ensure that workers do a good job?

D. Straight hourly wages for dock workers

Which of the following mergers is an example of vertical integration?

IBM purchases a California computer chip company.

Which of the following is the primary disadvantage of producing inputs within a firm?

Loss of specialization

Spot markets are generally preferable to:

None of the answers are correct.

Which type of compensation method does NOT involve a performance bonus?

None of the answers are correct.

Long-term contracts are generally preferable to:

None of the statements is correct.

Which of the following forms of payment is NOT an incentive plan?

Straight hourly wages for construction workers

The problem with spot exchange in the presence of specific assets is that both parties:

have incentives to behave opportunistically.

The agent is an individual:

hired by the principal to achieve goals

The LEAST risky payment plan from the viewpoint of the worker is:

hourly wage.

High transaction costs

may be a result of buyer opportunism.

Spot markets are an INEFFICIENT way for the firm to purchase inputs if:

opportunism is a problem and suppliers engage in hold-up.

The specificity of the asset (or investment) leads to the possibility of:

opportunism.

A manager who tries to enhance worker effort by tying workers' compensation to the profitability of the firm is using:

profit sharing.

To ensure quality, piece-rate plans must usually be accompanied by:

quality control mechanisms.

An increase in the likelihood of a dismissal:

raises productivity at a decreasing rate.

In order for spot checks to be effective, they must be:

random in nature.

An incentive for managers to maximize profits is:

reputation, performance bonuses, takeovers

Relationship-specific investments include:

site specificity, dedicated assets, human capital.

Spot exchange typically involves:

some transaction costs.

Long-term contracts are NOT efficient if:

specialized investments are unimportant.

When a manager enters the workplace from time to time to monitor workers, he is using:

spot checks.

Principal-agent problems do NOT arise between:

workers and consumers.

A potential problem with piece-rate plans is that:

workers may stress quantity instead of quality.

A potential problem with paying workers based on a piece rate is that:

workers will attempt to produce quantity at the expense of quality.

Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

10.6 percent

Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total compensation of the CEO, π = company profits (in millions) = $400, and S = sales (in millions) = $700. What percentage of the CEO's total earnings is tied to profits of the firm?

13.5 percent

If a firm manager has a base salary of $100,000 and also receives 5 percent of all profits, what percentage of his/her final income will be from a profit-sharing plan when profit equals $1,500,000?

43 percent

Suppose compensation is given by W = 100,000 + 157 π + 12S, where W = total compensation of the CEO, π = company profits (in millions) = $340, and S = sales (in millions) = $700. What percentage of the CEO's total earnings is tied to sales of the firm?

5.2 percent

Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in millions) = $400. What percentage of the CEO's total earnings are tied to profits of the firm?

7.8 percent

Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and the marginal cost of that contract is $100. Based on this information, the optimal contract length should be:

D. held constant at the contract length where MB = 100 and MC = 100.

17. Shirking can take the form of:

D. long lunch hours, sleeping at work, leaving work early

Spot checks

D. must be frequent enough to induce workers not to risk getting caught shirking.

As firms increase in size, they tend to experience a:

decrease in the need for managers, decrease in transaction costs, loss of opportunity cost. D. None of the answers are correct.

A decrease in the marginal benefit arising from a specialized investment will cause the optimal contract length to:

decrease.

An increase in the marginal cost arising from a more complex specialized investment environment will cause the optimal contract length to:

decrease.

Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and the marginal cost of that contract is $150. Based on this information, the optimal contract length should be:

decreased.

A decrease in the marginal cost arising from a less complex specialized investment environment will cause the optimal contract length to:

increase.

An increase in the marginal benefit arising from a specialized investment will cause the optimal contract length to:

increase.

A profit-sharing pay scheme:

increases both productivity and profits.

Relationship-specific exchange:

occurs because of specialized investments.

Vertical integration

occurs when a firm produces its own inputs.

Solving the principal-agent problem ensures that the firm is operating:

on the production function.

It would be undesirable to reduce the executive's compensation if her earnings are due largely to:

performance.

A spot exchange involves a market where goods are bought and sold at a:

prevailing market price.

Specialized investments:

result in relationship-specific exchange.

A payment plan that induces better worker effort by linking compensation to revenues of the firm is known as:

revenue sharing.

By instituting performance-based rewards to CEOs the profits of firms will:

rise.

By making managerial compensation depend on the performance of the firm's profits, the firm owner's profits:

rise.

EFI Conveyor Systems recently visited a local AC motor distributor. This transaction most likely involves:

spot exchange.

Sydney Roofers Incorporated recently purchased 100 pounds of standard roofing nails from Lowes, a nationwide hardware and building supplies store. This transaction most likely involves:

spot exchange.

The presence of minimal specialized investments relative to contracting costs suggests that the optimal input procurement method is:

spot exchange.

The principal's goals are NOT in line with the goals of:

the agents.

The activity known as shirking is LEAST likely to occur when:

the earnings of a worker are closely tied to the worker's output.

Long-term contracts are LESS likely when:

the exchange environment is complex.

Franchising mitigates

the principal-agent problem.

When the owner runs the business:

there is not a principal-agent problem.

The presence of substantial specialized investment relative to contracting costs suggests that the optimal input procurement method is:

vertical integration or contract.

General Motors purchased Fischer Auto Body to produce bodies to place on a chassis. This transaction is best described as:

vertical integration.

One way of alleviating opportunism is:

vertical integration.

9. An agent hired by the owner of productive resources to control the production process is:

D. a firm manager.

13. The disadvantage of vertical integration is that:

D. firms no longer specialize in what they do best.

Which of the following is an outside incentive that forces managers to put forth maximal effort?

Reputation

Suppose a firm manager has a base salary of $75,000 and earns 1.5 percent of all profits. Determine the manager's income, if revenues are $10,000,000 and profits are $5,000,000

$150,000

Suppose a firm manager has a base salary of $175,000 and earns 0.5 percent of all profits. Determine the manager's income if revenues are $10,000,000 and profits are $5,000,000.

$200,000

Suppose a firm manager has a base salary of $50,000 and earns 2.5 percent of all sales. Determine the manager's income if revenues are $20,000,000 and profits are $5,000,000.

$550,000

Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in millions) = $400. How much will this CEO be compensated?

$559,432

Suppose a firm manager has a base salary of $85,000 and earns 0.5 percent of all sales. Determine the manager's income if revenues are $2,000,000 and profits are $500,000.

$95,000

Determine whether the following transactions involve spot exchange, contracts, or vertical integration. a. A major oil company refines gasoline from crude oil produced by oil wells that it owns. b. Transcontinental, an interstate natural-gas pipeline, has a legal obligation to purchase a specified amount of gas per week from a well owned by Fred Smith in Enid, Oklahoma. c. A cabinetmaker purchases a dozen wood screws from the local hardware store. d. An electric utility purchases coal from an underground mine.

(a) Vertical integration; (b) contract; (c) spot exchange; (d) spot exchange or contract.

In a 1998 press release, Boeing Commercial Airplane Group (BCAG) announced that it was signing a 10-year contract with distributor Thyssen Inc., a distributor of raw aluminum, valued at approximately $300 million. The contract reflected Boeing's effort to reduce costs and production bottlenecks resulting from supply shortages. The contract specified prices and guaranteed quantities of raw aluminum to be delivered to BCAG's suppliers. If you were the production manager at BCAG, how would you justify the long-term nature of the contact with Thyssen Inc.?

A contract permits it to avoid the hold-up problem in the future, but the trade-off is the uncertainty of the future economic environment.

Art-R-Us makes hand-painted art reproductions. The owner-manager wishes to hire another artist, and is considering paying a fixed wage plus either (1) a share of the profits from each painting sold or (2) a fixed payment for each piece produced. Which plan would you choose if you were the owner? Explain.

A share of the profits from each painting sold. Unlike a piece rate, this would provide the artist a greater incentive to produce high-quality reproductions.

15. A person who monitors the production process and evaluates the productivity of workers is:

A. a manager.

The principal-agent problem refers to the fact that the agent's goals:

A. do not always coincide with those of the principal.

Which of the following involves the LEAST risk from the point of view of the employee?

Annual salary

One problem with revenue-based incentive schemes is they do NOT provide an incentive to:

minimize costs.

The principal-agent problem happens because the owner cannot:

monitor the efforts of the manager.

2. Which of the following forms of payment is NOT an incentive plan?

B. Flat salary for a plant manager

4. Which of the following is NOT a means of avoiding opportunism?

B. Spot exchange

11. A negative side of long-term contracts is:

B. a loss of flexibility.

Which of the following is NOT a benefit associated with producing inputs within a firm?

B. gains of specializing.

Given that the income for a franchise restaurant manager is directly tied to profits, while the income for the manager of a company-owned restaurant is paid a flat fee, we might expect profits to be:

B. higher in franchise restaurants.

8. A firm might choose to produce its own inputs if:

B. long-term contracts are costly to write

1. Often owners of firms who hire managers must install incentive or bonus plans to ensure that the:

B. manager will work hard.

6. A relationship-specific exchange occurs when:

B. specialized investments are important

In order for spot checks to work:

B. the time of the checks must not be predictable.

Suppose a new contracting environment that requires clearing fewer legal hurdles is considered. This new contract will result in:

C. a decrease in the marginal cost and a longer optimal contract.

Which of the following transactions are likely to result in relationship-specific exchange? a. Purchasing gasoline for the company car b. Hiring an employee to operate a machine that only your company uses c. Buying napkins for the company snack bar d. Purchasing coal for the factory furnace e. Buying electricity

Certainly b, and in some instances, d.

According to Industry Week, a shoe manufacturer recently had a production run that resulted in 100,000 pairs of defective shoes. Workers on the production line knew the shoes were defective as they were being produced, but did nothing to fix the problem. Do you think a profit-sharing plan for workers would mitigate future problems? Explain.

Clearly a profit-sharing reward scheme would have provided workers with an incentive to stop production. The bottom line is that if managers want workers to produce quality products, they must structure rewards that promote that goal.

Which of the following is NOT a type of specialized investment?

D. All of the statements associated with this question are types of specialized investments.

In general, automobile manufacturers produce their own engines but purchase tires from independent suppliers. Why?

Engine manufacturing involves specific investments; by vertically integrating, the potential for opportunism is reduced. Tires are more uniform and can usually be purchased by spot exchange.

Is it necessarily in the best interests of shareholders for management to ensure that there is absolutely no shirking in the workplace? Explain.

Ensuring absolutely no shirking in the workplace implies very high monitoring costs. There is a trade-off for shareholders between increasing productivity by reducing shirking and reducing the monitoring costs. The manager should reduce shirking to the point where the marginal benefit from reducing shirking equals the marginal cost of reducing shirking.

Which type of compensation mechanism works by threats?

Spot check

Which of the following methods might be an efficient way of obtaining inputs when specialized investments are not important?

Spot exchange

Which of the following institutions may result in hold-up?

Spot markets

Which of the following is NOT a solution to the manager-worker principal-agent problem?

Fixed hourly wages

Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound hamburgers in a given week. To meet that demand, Jiffyburger needs 2,000 pounds of ground beef delivered to its premises every Monday morning by 8:00 A.M. sharp. If you were the manager of a Jiffyburger franchise, how would you acquire the ground beef? Explain.

I would use a contract, since this would decrease the problems of opportunism while still allowing for specialization in production.

Which of the following is NOT an implication of specialized investments that lead to increased transaction costs?

Incentive contracts

Time clocks are typically a solution to the:

None of the statements is correct.

Dallas-based Southwest Airlines recently announced a 10-year contract that gives pilots a greater opportunity to share in the profits of the airline. According to the terms of the contract, the pilots will receive options to buy 14 million shares of the firm's stock over the next 10 years. What impact do you think this new contract will have on Southwest Airlines?

The contract provides pilots an incentive to take actions that will enhance Southwest Air's profits. Pilots will thus be more likely to strive for on-time departures, smooth flights, and to be courteous to passengers.

At the recent shareholders' meeting, the CEO of a small bank proposed a plan to offer each of its employees 250 incentive options for Class A common stock. The key provisions of the plan are that employees must exercise the options between January 2014 and December 2019, and if an employee terminates his or her employment with the bank (or is terminated), the options are no longer exercisable. One shareholder feverishly objected to the plan, claiming that such a move would dilute the value of the outstanding shares. As CEO, how would you defend the stock option plan to the shareholders?

The first important point to make with the shareholders is that this incentive plan is designed to maximize shareholder value. This is achieved by giving employees an incentive to stay with the company longer, thereby reducing costly employee turnovers and increasing the company's profitability. Also, by using the stock options as an 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.

You are the manager of Door-to-Door Vacuum Cleaners, Inc. Each salesperson is paid a base salary plus a percentage of the revenues she or he generates. In addition, each salesperson drives his or her car to and from each sales call and is reimbursed $0.40 per mile driven. On average, each salesperson drives about 150 miles per day and 240 days per year. As manager of Door-to-Door, how might you restructure the compensation of your sales force to enhance your profits? Are there any potential disadvantages of your plan? Explain.

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.

As a manager of the WeDoWell Corporation, you have negotiated with several vendors and are on the verge of signing an eight-year contract with Bolts Enterprises. Under the contract, they would ship to you 2,000 titanium bolts per month at a price of $1,000 per bolt. Your assistant has just brought you an article from a trade publication that indicates another company has developed a new technology that reduces the cost of producing the titanium bolts. How would this information affect the optimal length of your contract with Bolts Enterprises? Explain.

The reduction in another supplier's cost of producing titanium bolts reduces WeDoWell's marginal benefit of contracting. Therefore, the eight-year contract it has been negotiating is too long; the optimal contract length is now less than eight years.

Which of the following is NOT a solution to the manager-worker principal-agent problem?

The threat of a takeover

Suppose a new contracting environment with an economic environment that looks more uncertain is considered. This new contract will result in:

an increase in the marginal cost and a shorter optimal contract.

Which of the following is an outside incentive that forces managers to put forth maximal effort?

Threat of takeovers

College Retirement Equities Fund (CREF) is a pension fund that has billions of dollars invested in the stock market. Fund participants recently voted on a proposal that would have placed strict limits on the amount of compensation paid to CREF executives. Why do you think 75 percent of the participants voted against the proposal?

To the extent that the compensation paid to CREF executives is performance-based, executives receive large payments only if they are successful in increasing the net asset value of CREF funds. Capping compensation would thus reduce the executives' incentive to maximize the value of CREF funds, thereby reducing the overall return to the fund participants.

Which of the following is NOT a transaction cost associated with using inputs?

Wages paid to labor

Suppose a new contracting environment that requires less specialized investments is considered. This new contract will result in:

a decrease in the marginal benefit and a shorter optimal contract.

Spot checks work because of:

a potential penalty for shirking.

Transaction costs refer to:

costs of exchange unrelated to production costs.

Explain why people in the following occupations are compensated as they are. a. Insurance agents b. Football players c. Authors d. CEOs of major corporations e. Food servers

a. Insurance agents are usually compensated by a fixed base payment and a commission, which is positively related to the amount of business brought to the company. Without the variable part of salary, insurance agents have little incentive to find clients. b. Football players are usually compensated by a fixed payment, along with incentives tied to performance for reasons similar to the insurance agent example. c. Authors typically receive royalties, which are revenue-sharing plans whereby the author receives a fraction of the revenues generated by the book. This compensation scheme provides the author an incentive to write a high-quality book in order to generate lots of sales for the firm, and thus lots of royalty income for the author. d. A CEO of a major corporation is usually compensated by a fixed payment plus a variable bonus positively related to the amount of profits the corporation made. Without the variable part of the payment, the CEO will not put forth as much effort as desired by the principal. e. Waiters and waitresses are usually paid a small fixed payment by restaurants. The majority of their pay is derived from tips, since customers can monitor their servers while the restaurant manager cannot.

Explain how each of the following affects the optimal method of acquiring an input. a. A complex contracting environment b. A specialized investment c. Opportunism d. Bargaining costs e. The costs of bureaucracy f. Gains from specialization

a. Makes contracts a less attractive form of input acquisition. b. Makes spot exchange problematic, due to opportunism. c. Leads to more detailed contracts or vertical integration. d. Leads to longer contracts, or in extreme instances, vertical integration. e. Reduces the gains to vertical integration and lead firms to use contracts or spot exchange to acquire inputs. f. Reduces the benefits of vertical integration.

A manager derives satisfaction from income and leisure on the job (shirking). a. If the manager is paid a fixed salary of $100,000, how much leisure will she consume on the job during an eight-hour day? Explain. b. When the manager is given a salary of $100,000 plus 10 percent of the firm's profits, she chooses to spend six hours managing and two hours consuming leisure. Salary and bonus total $120,000. Does the manager necessarily prefer this situation to the situation in part (a)?

a. She will consume the whole eight hours as leisure because working (putting forth effort) causes dissatisfaction to the manager. Hence the manager will shirk if there is no punishment for doing so. b. The manager does prefer this situation to the situation in (a). There are two consumption bundles now: (1) $100,000 salary plus eight hours of leisure a day, and (2) $120,000 salary plus two hours of leisure a day. Since the original choice of eight hours shirking and $100,000 is still available, the fact that she chose to work two hours reveals that she prefers the second pay scheme.

Discuss the benefits and costs of the following methods of monitoring worker performance: a. Hidden video cameras in the workplace. b. Time clocks. c. Paying workers based on the output they produce.

a. The benefits are that it may be effective. The problem is that it affects the morale of the workers. Moreover, extra employees are required to watch the video. b. The major benefit of using time clocks is that they verify that workers show up to work. However, they do not provide any incentive to work once the workers are at the workplace. c. The benefits are that the manager can know the performance of individuals. The costs are that it may be costly to do so, and when the output is completed by teamwork or quality is hard to evaluate, it is difficult to know an individual worker's performance.

Suppose a principal knew with certainty the level of profits that would result if an agent put forth maximum effort. a. Would there be a principal-agent problem? b. Devise two incentive contracts that would induce the manager to put forth maximum effort in this instance.

a. There would not be a principal-agent problem if the principal could devise a contract such that the agent has no incentive to shirk. b. Incentive Contract 1: Pay the manager a percentage of profits, provided profits are maximal. Otherwise, pay nothing to the manager. Incentive Contract 2: The manager is paid a fixed salary if the profit reaches the maximal profit; the manager is paid nothing otherwise.

Suppose a new contracting environment that requires greater specialized investments is considered. This new contract will result in:

an increase in the marginal benefit and a longer optimal contract.

Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and the marginal cost of that contract is $50. Based on this information, the optimal contract length should:

be increased.

Long-term contracts:

can reduce opportunistic behavior.

The most commonly used negative incentive used by firms is:

dismissal.

Point B in the figure below is:

efficient since it produces 10 units of output at the lowest possible cost

A long-term contract:

exists when a firm is legally bound to purchase inputs from a particular supplier.

The threat of a corporate takeover is an _________ incentive that helps to mitigate the _________ principal-agent problem.

external; owner-consumer

Managerial reputation is an _____ incentive that helps to mitigate the _______ principal-agent problem.

external; owner-manager

If we reduce performance-based rewards to CEOs, the profits of firms will:

fall.

A negative side of a revenue-sharing plan is that it:

gives no incentive for workers to minimize costs.

Point A in the figure below is:

inefficient since it produces 20 units of output at a cost greater than the minimum cost.

A positive side of long-term contracts is:

low transaction costs.

Given that the income of franchise restaurant managers is directly tied to profits and the income of the manager of the company-owned restaurant is paid a flat fee, we might expect profits to be:

lower in company-owned restaurants.

Piece rates are typically a solution to the:

manager-worker, principal-agent problem

Spot checks are typically a solution to the:

manager-worker, principal-agent problem.

Generally, revenue-based incentive schemes:

reduce incentives to produce low-quality products.

An example of a job that usually involves a revenue-sharing plan would be:

waiters and waitresses, car salesman, insurance agents

Long-term contracts become shorter:

when specialized investment becomes less important.

A firm chooses the institution to purchase inputs:

which minimizes the transactions costs of obtaining inputs.

Revenue sharing tries to induce worker effort by linking:

worker compensation to revenues.

Which of the following involves the most risk from the point of view of the employee?

Profit sharing

Which type of compensation method works by performance bonus?

Profit sharing, Revenue sharing, Piece rate

The cost to a manager of doing a poor job running the firm is:

an increase in the likelihood of being replaced.