INDIVIDUAL PRACTICE EXERCISES MARCH 21st

1. What is NOT a characteristic of a relationship-specific investment?

a) There is a risk of hold up by one of the parties
b) Both parties are dependent on each other
c) Part of the cash flows is locked in the relationship
d) There is always an opportunity to recover the investment

2. The problem of a relationship-specific investment arises from:

a) The uncertainty related to the distribution of quasi-rents
b) The lack of competition for contracts
c) Mutual dependency of the partners
d) All of the above

3. The North Stream gas pipeline case discussed in class is an example of mainly:
a) Technology-specific investment
b) Location-specific investment
c) Knowledge-specific investment
d) Talent-specific investment

4. In a fully specific investment (s=100%) the investor:

a) Will be able to appropriate at least half of the quasi-rents
b) May lose the entire value of her investment if the relationship breaks
c) May be able to reemploy the investment elsewhere
d) Will not incur any transportation costs

5. Quasi-rents refer to:

a) Part of the profits and investment costs that are locked to a particular relationship
b) Profits generated from alternative projects in the case if the relationship breaks
c) The profits lost from abandoning an investment project
d) The loss in the investment in case the relationship breaks

6. If a project that involves a relationship-specific investment has a positive NPV it

means that:
a) The project is profitable and therefore should be carried out
b) The project is not profitable and therefore should not be carried out
c) The project is profitable, however, this is insufficient to determine whether to
invest or not
d) The wealth generated will allow the partners to cover their investments

7. Which of the statements about price negotiations between two parties involved in
an asset-specific contract is NOT correct?
a) The upper price limit of negotiated price is the value attributed to the product by
the business partner
b) The upper price limit of negotiations will always capture full quasi-rents
c) The bottom price limit of negotiations will always cover the unit cost
d) The bottom price limit of negotiations will always cover the variable costs
 8. As an investment in an asset becomes more specific in an arms-length
contractual relationship:

a) The quasi-rents increase

b) The quasi-rents decrease
c) The costs of internal coordination increase
d) The risk of opportunism decreases

9. Explain why abandoning a specific investment because of a threat of

opportunism by one of the parties may not necessarily be the optimal solution:

Answer:

10. Consider the following pairs of situations. In each pair, which situation is more
likely to be susceptible to coordination problems?

a) Coordination between the owners of the land and farmers who do not own the land
and grow 1) annual wheat crops or 2) almond trees on this land

Answer:

Ex. 2
Voz-Telekom is leader in the telecommunication sector and is designing a new project for
internet phone. It has two possibilities, both within a 3 year time span that will allow
producing a total of 1.6 million units:
Investment Alternative A: Voz-Telekom may develop a product that is specific to the
Microsoft Windows, which would yield the product with client value of €200. The
investments required from Voz-Telekom are €200 MLN in equipment and facilities and
variable costs of 20 € per unit. If that option was chosen, the product could never be sold or
adapted to any customers other than Microsoft.
Investment Alternative B: The existing alternative would be to acquire equipment not as
sophisticated as the previous one but that allows to make a product for which consumers
would be willing to pay up to 180 € per unit. In addition, with minor modifications (we will
suppose that the cost of these changes is zero) these products could be sold to other
customers, rivals of Microsoft, for a market price of 170 Euros. In this scenario, the necessary
equipment investment is 120 millions and the variable costs are 80 € per unit.
a. Which option would generate higher wealth for both parties?
b. What are the quasi rents and the degree of investment specificity for each alternative?
c.Which option should Voz-Telekom chose? Assume the bargaining power of VT is 50%.
Justify numerically your answers.
d. Calculate the transaction costs associated with this situation and explain the results.
e. Under what contractual conditions would you advise to carry out investment A?

Solution:
 a) Option A creates more value and is more profitable than Option B

A: CFmax=288 MLN, Rent=88 MLN

B: CFmax=160 MLN, Rent=40 MLN

b) Option A has higher QR: QRA=288 MLN; QRB=16 MLN

Option A is 100% specific investment, whereas Option B is not specific investment
(QR<R).

c) If Bargaining power is 50% then the price will be the following:

Option A:
Vcl >p>VOcl
200>p>20
P= 𝑽𝟎CL+ 𝜶(𝑽𝑪𝑳 - 𝑽𝟎CL)
p=110
Profits per unit: -35

Option B:

VOcl=170
180>p>170
P=175
Profits: 20
Thus, option B is the preferred one.

d) Transaction costs associated with this case refer to the wealth lost (or not created) due
to transacting through the market. If the firm choses AltB over Alt A, the wealth not
generated equals 88-40=48 MLN.
e) Alt A will be preferable when it will allow to generate rents for VT > 32 MLN or
profit per unit >20 or p>165

165=20+ ∝(200-20)
To choose Alt A VT needs to assure ∝³0.81