UNIVERSITY OF ROCHESTER STR 403 Professor Gerard Wedig ...
UNIVERSITY OF ROCHESTER STR 403 Professor Gerard Wedig ...
UNIVERSITY OF ROCHESTER STR 403 Professor Gerard Wedig ...
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<strong>UNIVERSITY</strong> <strong>OF</strong> <strong>ROCHESTER</strong><br />
WILLIAM E. SIMON GRADUATE SCHOOL <strong>OF</strong><br />
BUSINESS ADMINI<strong>STR</strong>ATION<br />
<strong>STR</strong> <strong>403</strong><br />
<strong>Professor</strong> <strong>Gerard</strong> <strong>Wedig</strong><br />
Economic Theory<br />
Office: CS3 – 160J<br />
Of Organizations Phone: 273-1647<br />
Winter, 2009<br />
Email: wedig@simon.rochester.edu<br />
Assistant: Kate Walsh<br />
MIDTERM EXAMINATION ANSWERS<br />
Mean: 41.4<br />
Standard Deviation: 8.8<br />
Name____________________________________<br />
1) This is a closed book, closed note exam.<br />
2) The clarity and succinctness of your answers are crucial. Think first and use a<br />
well structured approach to answering each question. Neither I nor the graders are<br />
obligated to search for the correct answer in the midst of unrelated or incorrect<br />
material.<br />
3) All answers should be completed in the space provided<br />
4) Most or all of the questions can be answered with just a few carefully selected<br />
sentences.<br />
Question 1 (10 Pts.)<br />
Question 2 (10 Pts.)<br />
Question 3 (10 Pts.)<br />
Question 4 (10 Pts.)<br />
Question 5 (10 Pts.)<br />
Question 6 (10 Pts.)<br />
____________<br />
____________<br />
____________<br />
____________<br />
____________<br />
____________<br />
Total ___________
1. Economic Man (10 Pts.)<br />
In the Wall Street Journal (WSJ) edition of Tuesday, February 10 th , 2009, it was reported<br />
that car accident deaths in the U.S. fell in 2008. Moreover, the article also reported that<br />
the death rate also fell per mile driven.<br />
The WSJ article goes on to say that gasoline prices were significantly higher in 2008 than<br />
in past years and that most automobiles achieve their best gas mileage at speeds<br />
between 30 MPH and 60 MPH. Finally, assume that fatalities are generally associated<br />
with high rates of speed, often in excess of 75MPH.<br />
a. (4 Pts.) Use the economic model of behavior to offer an explanation for how the<br />
rise in gas prices could have lead to a reduction in mortality per mile driven in<br />
2008. Be sure to mention relevant key assumptions of the economic model in<br />
your explanation.<br />
Answer: In the economic model of behavior, individuals substitute among goods based on<br />
their relative prices. As gas prices go up, the price of speed on the highway goes up as well.<br />
This causes individuals to demand less of it and to slow down. This will reduce the death<br />
rate per mile driven.<br />
Partial Credit: 2 pts for explaining that the price of going fast has increased and 2 pts for<br />
drawing the implications of this.<br />
b. (6 Pts.) For years, many advocacy groups have advocated strict enforcement of<br />
highway speed limits in order to reduce the mortality rate per mile driven.<br />
o<br />
According to the economic model of behavior discussed in class, what<br />
factor reduces the effectiveness of speed limits as a device to control<br />
driving speeds<br />
Answer: In class we noted that individuals are clever and creative. They have devised<br />
methods to evade the legal constraint against going fast by using radar detectors etc.<br />
Partial Credit: 2 pts for “clever and creative” and 1 pt for the rest of the answer.<br />
o<br />
Using the lessons from part a) can you suggest alternative public policy<br />
for reducing highway mortality<br />
Answer: An alternative policy that might work would be to raise the tax on gasoline. This<br />
will cause people to slow down voluntarily and reduce mortality.<br />
Partial Credit: 1 pt for valid suggestion and 2 pts for rest of the answer.
2. Agency Costs (10 pts.)<br />
A factory manager wants to hire an employee to assemble products. Suppose that the<br />
employee is capable of two effort levels (“Low” and “High”) resulting in the following<br />
costs and value creation.<br />
EFFORT LEVEL COST <strong>OF</strong> EMPLOYEE<br />
EFFORT<br />
PRODUCT VALUE<br />
CREATED<br />
Low $100 $200<br />
High $200 $500<br />
In this case, “Cost of Employee Effort” is the dollar-equivalent cost to the employee of<br />
exerting the effort levels indicated. “Product Value Created” is the amount that the<br />
employee’s effort adds to the company’s value.<br />
a. (3 Pts.) Provide a concise definition of “agency costs.”<br />
Answer: Agency costs arise where individuals do not bear the full costs (or reap the full<br />
benefits) of their actions. Agency costs include Out-of-pocket costs to control incentive<br />
problems and Residual loss because it does not pay to perfectly control incentive problems.<br />
Partial credit: 2 pts for a reasonable definition and 1 pt for mentioning both out of pocket<br />
costs and residual loss.<br />
b. (4 Pts.) Assume that, due to difficulties in monitoring, only a low effort contract<br />
can be enforced. What is the value of the resulting agency cost Explain your<br />
answer.<br />
Answer: The agency cost is the loss in contract value from not being able to enforce the high<br />
effort contract. Surplus from the low effort contract is $100 while it is $300 from the high<br />
effort contract. So the agency cost is the difference, or $200.<br />
Partial Credit: 4 pts for a correct numerical answer and nothing incorrect said in the<br />
explanation. 2 pts potential partial credit for a good explanation but the wrong numerical<br />
answer. 2 pts partial credit for the correct numerical answer but faulty reasoning behind the<br />
answer.<br />
c. (3 Pts.) Assume that if the plant manager invests $50 in plant supervision, the<br />
high effort level can be enforced. Will the manager make this investment What<br />
is the dollar value of agency cost now Will the employee oppose such an<br />
investment Explain.<br />
Answer: Yes he will make the investment because the reduction in agency cost exceeds $50.<br />
Agency cost is now $50, the out-of-pocket cost referred to in part (a). The employee will not<br />
oppose this so long as he is paid fair compensation (or better) for his effort. The employer<br />
can afford to compensate them for their added effort given the increase in value created.<br />
Partial Credit: 1 pt for each part.
3. Decision Rights (C vs. D) (10 Pts.)<br />
The modern automobile industry has changed greatly in the past 50 years. Years ago,<br />
when General Motors controlled 50% of the American market, there were roughly 30 car<br />
models around, half of which were made by General Motors. Production runs for<br />
individual models were large – for example, GM produced over 500,000 Chevy Impalas<br />
per year.<br />
Now, there are over 600 different models on the market, General Motors’ market share<br />
has eroded to a fraction of its previous level and a successful single care model may sell<br />
300,000 copies over its entire lifetime. A couple of years ago, an article in the Economist<br />
reported, “the trick is to make different models using the same underpinnings of parts<br />
unseen by consumers.” (Please ignore the effects of the recent financial crisis in<br />
formulating your answers below).<br />
a. (5 Pts.) In the “old days” the organizational structure of General Motors, known<br />
for its different automobile divisions, was famous for both centralizing and<br />
decentralizing key tasks. For example, marketing and new model introduction<br />
decisions were centralized while key operating and engineering decisions were<br />
decentralized to the divisions, whose managers were incented based upon the<br />
profits of their division.<br />
What was the rationale for centralizing marketing and decentralizing operational<br />
decisions in the “old” GM model<br />
Answer: Because GM controlled such a large share of the market, any new model<br />
introduction or marketing campaign risked cannibalizing its own market. Hence, new<br />
model introductions and marketing needed to be coordinated centrally. Likewise, because<br />
production runs were so large at each division, each division could achieve economies of<br />
scale on their own. Hence production decisions could be decentralized.<br />
Partial credit:<br />
3 pts for marketing and 3 pts for production, maximum of 5.<br />
b. (5 Pts.) In the new era described above, it makes sense to re-evaluate the<br />
allocation of marketing and production decision rights. How do changes in<br />
GM’s environment change the way in which marketing and operating decision<br />
rights should be allocated Explain your reasoning.<br />
In the new era, marketing and model introductions can be decentralized because GM does<br />
not cannibalize its own market as much and because there is intense competition to market<br />
in a timely fashion. On the other hand, production and engineering decisions need to be<br />
centralized because divisions need to share parts and car platforms. These decisions need to<br />
be coordinated across divisions.<br />
Partial credit: Same as part a.
4. U Vs. M Form (10 Pts.)<br />
An owner-manager operates several retail clothing stores in a single market.<br />
The manager has a unique South American source for the company’s inventory of<br />
original alpaca clothing. Organizationally, the company uses a classic “U form” model<br />
of organization. That is, the owner-manager closely supervises and coordinates all of<br />
the major business functions, including purchasing, retail (store) management,<br />
marketing and finance. Individual managers also oversee these functions so that, for<br />
example, there is a head of marketing who reports directly to the owner. The owner<br />
provides bonuses to her top managers based upon subjective evaluations of their work.<br />
Because of its recent success, the company is planning to open locations (new stores) in a<br />
neighboring state. The owner will not be able to monitor the new stores as effectively<br />
as she monitors local operations.<br />
a. (5 Pts.) A recent graduate of this class has suggested to the owner that she use an<br />
“M form” management structure for the new stores. Each new store would be a<br />
unique “product” or division with its own decision rights over inventory,<br />
marketing and overall store operations. Each store would also have its own P<br />
and L statement.<br />
List and explain (2) advantages this would provide compared to the case where<br />
the new store operations were simply folded into the existing U form.<br />
Answer: The major advantage is that each store manager can be held accountable for their<br />
own performance by using the store’s P and L statement. This helps to address the problem<br />
of monitoring cited above. Second, providing the store managers with decision rights over<br />
issues such as marketing and inventory will allow them to make use of specific knowledge<br />
about conditions in their own market.<br />
Partial Credit: 3 Pts for the first advantage (with explanation) and 2 pts for the second.<br />
b. (3 Pts.) List and explain one disadvantages or concern that the owner might have<br />
with the M form strategy for new stores.<br />
Answer: The company may lose the advantage of scale in areas such as marketing. Also, the<br />
stores in the other state may compete with one another (not coordinate their efforts.)<br />
Partial credit: 1 pt for a disadvantage and 2 pts for the explanation.<br />
c. (2 Pts.) Why does it make sense to continue to centralize a function such as finance<br />
(payroll, taxes, treasury etc.)<br />
Answer: There is nothing unique about these functions that justify each store coordinating<br />
them. They are also scalable. Finally, there is considerable risk to the company as a whole if<br />
they are performed incorrectly.<br />
Partial Credit: 2 pts for a valid reason with explanation.
5. Incentives (10 Pts.)<br />
Most experts predict that the current recession will extend well into the coming year<br />
(2009) and perhaps into 2010. During this time period, sales for most companies are<br />
expected to decline relative to their prior year values, although considerable uncertainty<br />
remains about what will actually happen to sales in 2009 (greater uncertainty than in the<br />
past).<br />
Consider an electronics manufacturing company, with its own sales force. In this<br />
company, 40% of compensation has historically been based upon commissions (a fixed<br />
percentage of sales made is paid to the sales force). The sales people each sell in<br />
different assigned territories. The territories, while different, have similar sales<br />
environments and are equally impacted by the current recession, so that a salesperson<br />
using the same effort and ability will book the same sales in any of the territories.<br />
a. (5 Pts.) The head of sales has suggested that “it would be unfair and unwise to<br />
base 40% of salesperson’s pay upon commissions in 2009, when it is well know<br />
that sales will decline in the coming year”.<br />
Using the theory of incentive pay and performance assessment, suggest and<br />
explain a legitimate reason to support this position. Your reasons should<br />
explain why it would be unwise for the firm to place the same weight on<br />
commission-based pay in the coming year, using the theory of incentive pay<br />
and performance assessment.<br />
Answer: The environment is characterized by greater risk and uncertainty which theory<br />
says should reduce the reliance on incentive pay.<br />
Partial credit: 2 pts for reason and 3 pts for explanation.<br />
b. (5 Pts.) Suggest a way to change or reform the commission-based system in the<br />
coming year so that it may work more effectively in the context of the general<br />
climate of economic uncertainty.<br />
Answer: Relative performance assessment may work. Presumably the sales territories are<br />
equally affected by the economy, so RPE can be used to remove the uncertainty of the<br />
economic climate.<br />
Partial Credit: 2 pts for answer and 3 pts for explanation.
6. (10 Pts.) Incentives and Performance Assessment Measures<br />
In the early 1990s, a major manufacturing company lagged behind its competitors in<br />
worker safety. Injuries were up to 10 times as high compared to other top firms. Most<br />
injuries occurred due to a combination of plant conditions (unsafe arrangement of<br />
machines and processes) or worker carelessness (e.g., putting hands inside of machines<br />
during repair).<br />
In response, this company undertook a major initiative to change company culture and<br />
improve the injury rate. The major elements of the program were: 1) visible support by<br />
executive and divisional leadership (strong message: “we care about this”); 2) education<br />
programs that were attended by the leadership of each plant and; 3) a statement from<br />
management that each plant manager would be held accountable for promoting a health<br />
and injury free environment, although no explicit incentive plans were provided.<br />
a. (4 Pts) If the company wanted to promote safety at the plant level, why didn’t it<br />
simply allocate safety goals to each plant manager together with explicit<br />
incentives to achieve them List and explain (2) difficulties that might exist with<br />
using a scheme of this type. Be specific.<br />
Answer: The difficulties with an incentive scheme would be: 1) setting reasonable standards<br />
for improvement with no knowledge of what was attainable in the short run; 2) it may have<br />
been difficult to find reasonable metrics of improvement that wouldn’t be gamed (e.g.,<br />
workers may be encouraged to not report injuries if the manager was rewarded for holding<br />
the injury rate down); 3) the multi-task principal-agent problem may make if difficult to<br />
configure effective incentives without sacrificing productivity; 4) top management may have<br />
specific knowledge about how to improve safety that needs to be transmitted to the plants.<br />
Partial Credit: 2 pts for each difficulty with setting standards (with explanation).<br />
b. (3 Pts.) Given the difficulties that you cited in part (a), what role did visible signs<br />
of management’s support for safety play in achieving the safety goals<br />
Answer: Incentives to improve safety were implicit. Management has to engender trust that<br />
it would reward good safety performance, even in the absence of explicit incentives. Visible<br />
signs of support for safety improvement were a way to engender trust that desired behaviors<br />
would be rewarded.<br />
Partial Credit: 2 pts for mentioning implicit incentives, 1 pt for explanation.<br />
c. (3 Pts.) Given the types of incentives in play, would you expect improvements in<br />
safety to take longer than the case where (workable) explicit incentives were<br />
provided Explain.<br />
It would take longer because managers would first have to develop a trust and understanding<br />
that safety really matters. This would take time as reputation is only developed based on<br />
tangible responses that occur in response to given actions (e.g., managers with good safety<br />
records actually get promoted). Partial Credit: 1 pt for answer and 2 pts for explanation.