Answers to Back-of-the-Chapter Problems
1. a. We know that Pr(L) = .04, Pr(R | L) = .5, and Pr(R|N) = 1/16, where L
denotes lemon, R denotes return, and N denotes normal car. The joint
table is
Lemon (L) Normal (N) Total
Here, one computes the first row as: Pr(L & R) = (.5)(.04) = .02, and
b. We see that the return policy screens out half of the lemons (a
2. a. Commissions can lead to both adverse selection and moral hazard
problems. The Sears compensation system may have attracted dishonest
employees who saw a chance to make money by defrauding customers.
b. The management of Sears may not have much incentive to monitor its
employees and discover the abuses. After all, the employees were
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c. The downside of changing the compensation structure is that employees
3. a. With equal chances of both types of workers, the firm offers a wage of
b. By attending college, HP workers can distinguish themselves from LP
workers (i.e., signal their higher productivity). Consider an equilibrium
in which workers with college educations are paid $45,000, and all
others are paid $30,000. By going to college, HP workers increase their
4. First, from the university’s point of view, it is probably relatively
inexpensive to offer these educational benefits. (The marginal cost to
5. If the bill is split five ways, each time a couple orders an extra menu
item (say, an expensive shrimp cocktail or a baked Alaska dessert), its
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6. a. The possible advantage is that carrying out the IMRT on an out-patient
b. First, reimbursement on a fee-for service basis tends to encourage
overprovision of services. Second, by owning the equipment, urologists
directly profit carrying out the treatment. Therefore, they may tend,
7. a. Guarantied deliver is not efficient, because it forces Firm X to deliver
b. Setting the penalty at $50,000 is also NOT efficient. For instance, Firm
Y would default with a cost such as c = $70,000 (it’s cheaper to pay the
penalty), even though Firm X’s value is much higher ($100,000).
8. The corporation favors the arrangement because it obtains a guaranteed
price. (This price is slightly below the price the underwriter will set for
the shares on the market. The difference is the underwriter’s profit.).
The company also knows that the underwriter will have a strong
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9. a. Having only imperfect information, the winning bidder may have been
overly optimistic about the player’s “true” long-run ability. (For
b. If a ball player is guaranteed exorbitant sums for the duration of his
contract, he may have a reduced incentive to give a 100 percent effort
c. An owner should estimate what a player is worth based on the best
10. A seniority system avoids influence costs, that is, the maneuvering,
negotiation, and office politics that inevitably occur when one person
11. Although team decision making can generate valuable information and
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costly (enlisting additional human resources) and time-consuming. In
12. a. No, the plant manager will report a much lower output, so that his
b. Under the new bonus schedule, the manager will always strive for
maximum output (because the bonus depends positively on actual
output) and will also have the incentive to report the plant’s true
using the second equation of the bonus payment. Alternatively, if he
using the first equation of the bonus payment. Any overstatement or
Discussion Question
a. Economic activities are undertaken within the firm when they are
cheaper to do internally than through an external market. As IT has
reduced the cost of external transactions, firms have transferred a
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b. An effective IT system allows efficient information sharing which can
benefit both centralized and decentralized decision making. As we saw in
the DHL case earlier, the efficient transmission of cost information to
c. IT systems make it easier to monitor and measure worker performance.
Consequently, they go hand in hand with greater reliance on incentive
Spreadsheet Problem
S1 a. To find the worker’s optimal level of effort, we use the optimizer to
b. By hand or using the optimizer, we find the worker’s optimal effort
levels are 20, 30, 40, and 50 for sharing rates .4, .6, .8, and 1.0
c. Using the optimizer, we can find the value-maximizing contract by
maximizing total profit in cell C17 by varying cells C7 and D7,
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d. Here, we set the sharing rate in cell C7 equal to zero and simply
Note to Instructor. The solution in part c can be found by the usual
calculus methods. The goal is to maximize:
Total profit = Employer’s Profit + Worker’s Risk Adjusted Profit
The employer sets b and the worker chooses his effort to maximizes his
(This formula confirms the effort schedule in part b.) Now we can substitute
E = 50b into the total profit expression to obtain:
Maximizing this expression with respect to b implies the first-order
condition:
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