MIDTERM ECON 3110 SPRING 22

Total Time: 2 hours, Open Book.

All questions from Milgrom and Roberts Textbook ‘Economics, Organization & Management’
Mathematical Questions:
1. Suppose that, in the context of the example in the text of the Spence model of education as a signal, the
high-ability workers are relatively more numerous, making up 80 percent of the work force, but that the
costs of acquiring education and the productivities are as in the text (that is, is CII = $10 and CL = $20,
while wages are $ 50 for the high-ability workers and $20 for the low). Determine how large EH, the
level of education chosen by the high-ability workers, must be to be a credible signal if the level chosen
by the low-ability workers is 0. Show that the high-ability workers would be better off if there were no
signaling (for example, if C11 were to rise to $20). 10 marks
2. (Forcing contracts). ln principal-agent problems of efforts provision, moral hazard may not be a
problem if the structure of uncertainty allows the principal to infer precisely whether the agent has failed
to perform as desired. To see this, suppose in the context of the example in the Appendix that the
matrix relating the probabilities of various outcomes were changed so that the high level of revenues
(30) was sure to occur if the worker supplies the high level of effort (e = 2), but either level of revenue
could still happen if the low level of effort (e = 1) is provided. Thus, the first row of Table 6. 5,
corresponding to e = 1, is unchanged, but the entries corresponding to e = 2 become O and 1 instead of
1/3 and 2/3. Rewrite the incentive and participation constraints and show that it is possible to design
a forcing contract that motivates the worker to work hard, supplying e = 2, without placing any risk on
him or her. How much is the worker paid if revenues of 10 are realized? How much when revenues are
30? What arc the expected utilities of the two parties? Is there any cost in this case to effort not being
observable, that is, could the parties do better if effort were observed? Would it be possible to achieve
this sort of result if the low level of effort surely resulted in revenues of 1 0, but the high level of effort
could result in either revenues of 10 (with probability 1/3) or 30 (with probability 2/3)? Why or why
not? 15 marks
OR
(Selling the firm to a risk-neutral agent). In many principal-agent problems of effort provision, moral
hazard is costly if the agent is risk-averse because making his or her pay reflect the full marginal impact
of his or her effort choices imposes costs on the agent that could be avoided if the risk-neutral principal
absorbed the variability in incomes. Again in the context of the example in the Appendix, show that if
the agent is risk-neutral, with utility function for income w and effort e of u(w,e) = w - (e - 1 ), then it is
possible to achieve the same expected utilities for both parties as would result if effort were observable
by having the agent bear all the risk and the principal receive an amount that is independent of the
realized level of revenues. 15 marks
3. …..we compared the advantages of relative performance evaluation against an evaluation based
solely on the employee's own performance. Here we consider all combinations of the two as well.
Thus, suppose manager A's measured performance is eA + xA + xC and B's measured performance is
eB + xB + xC, where xA, xB, and xC are independent sources of randomness. Suppose it is proposed to
base manager A's compensation on his or her own performance minus δ (delta) times some measure of
B's performance. Find the value of δ that minimizes the variance of the performance measure
(Holmstrom’s Informativeness Principle). How does this value change with changes in Var(xA)?
Changes in Var(xB )? Changes in Var(xC)? 15 marks
Non – Mathematical Short Questions:
4a. In fast-food chains, some decisions about standards are made centrally and others are left to the individual
outlet managers. Who typically makes which kinds of decisions? Why? Can you think successfully about the
fast-food business by dividing the issues between coordination and motivation? 5 marks
4b. Armies in battle have especially severe organization problems. What kinds of decisions are made centrally,
and which are left to commanders in the field? What principles dictate the division? Can you think successfully
about the problems of military organization by dividing the issues between coordination and motivation? 5
marks
5a. Would you expect the organization of agriculture in developing countries to be arranged in a way that
maximizes the total wealth of the farmers, workers, and lenders? If arrangements do not maximize total wealth,
what kind of variations would be most likely? Explain your answer. 5 marks
5b. In California's fruit farms, farm workers who pick fruit are commonly organized into teams that are paid
according to the number of trees that are cleanly picked. The teams themselves decide how to divide the pay
among their members. What attributes of this transaction account for this arrangement? 5 marks

Plus a bonus question given after 1 hour 30 minutes when it was found that the students had difficulty
solving the mathematical part.