Microeconomics 13th Edition Parkin

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 C h a p t e r
10 ORGANIZING
PRODUCTION

Answers to the Review Quizzes

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1. What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this goal?
A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either
eliminated or bought out by other firms maximizing profit.
2. Why do accountants and economists calculate a firm’s cost and profit in different ways?
Accountants and economists have different reasons for computing a firm’s costs. An accountant
calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax
and to show its investors how their funds are being used. An economist calculates a firm’s cost
and profit in a way that enables him or her to predict the firm's decisions.
3. What are the items that make opportunity cost differ from the accountant’s measure of
cost?
A firm’s opportunity cost includes the cost of using resources bought in the market, owned by
the firm and supplied by the firm's owner. Economists and accountants both include the price of
resources bought in the market as costs. But accountants omit costs included by economists. For
instance, use of a building the owner has already purchased has an opportunity cost that
accountants do not include. Additionally the normal profit, interest foregone, and economic
depreciation are other opportunity costs not recorded by an accountant.
4. Why is normal profit an opportunity cost?
Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability
and labor to the firm’s production process. Using the owner’s ability to run the business implies
that the owner could have received a return for using it in another capacity, such as running
another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone
alternative, which is running another firm, and must be included in calculating the firm’s
opportunity cost of production.
5. What are the constraints that a firm faces? How does each constraint limit the firm’s profit?
The three types of constraints a firm faces are technology constraints, information constraints,
and market constraints. Technology is any specific method of producing a good or service and it
advances over time. Using the available technology, the firm can produce more only if it hires
more resources, which will increase its costs and limit the profit of additional output.
Information is never complete, for the future or the present. A firm is constrained by limited
information about the quality and effort of its work force, current and future buying plans of its
customers, and the plans of its competitors. The cost of coping with limited information itself
limits profit. Market constraints mean that what each firm can sell and the price it can obtain are
constrained by its customers’ willingness to pay and by the prices and marketing efforts of other
firms. The resources that a firm can buy and the prices it must pay for them are limited by the
willingness of people to work for and invest in the firm. The expenditures a firm incurs to
overcome these market constraints will limit the profit the firm can make.
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1. Is a firm technologically efficient if it uses the latest technology? Why or why not?
Technological efficiency occurs when a firm produces a given level of output using the least
amount of inputs. Adopting the latest available technology does not necessarily imply that a
firm’s production process is technologically efficient. As long as the firm is getting the maximum
possible output for a given combination of inputs, it is technologically efficient.
2. Is a firm economically inefficient if it can cut its costs by producing less? Why or why not?
Economic efficiency occurs when the firm produces a given level of output at the least cost. If a
firm can decrease production costs by decreasing output, it is not necessarily economically
inefficient. If it is producing the new level of output at the least possible cost, it is achieving
economic efficiency.
3. Explain the key distinction between technological efficiency and economic efficiency.
The difference between technological and economic efficiency is that technological efficiency
concerns the quantity of inputs used in production for a given level of output, whereas economic
efficiency concerns the value of the inputs used. Economic efficiency requires technological
efficiency, but technological efficiency does not require economic efficiency.
4. Why do some firms use large amounts of capital and small amounts of labor while others
use small amounts of capital and large amounts of labor?
The mix of resources used, such as large amounts of capital versus small amounts of capital,
depends on economic efficiency. Economic efficiency is based on minimizing the value of the
resources used, not the quantity. A firm will use the mix that produces output at the lowest
possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of
capital decreases relative to the cost of other resources, capital-intensive production methods
will become economically efficient and firms will avoid labor-intensive methods.

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1. Explain the distinction between a command system and an incentive system.
A command system uses a managerial hierarchy, where commands pass downward through the
hierarchy and information (feedback) passes upward. These systems are relatively rigid and can
have many layers of specialized management. Incentive systems use market-like mechanisms to
induce workers to perform in ways that maximize the firm’s profit.
2. What is the principal-agent problem? What are three ways in which firms try to cope with
it?
The principal-agent problem is the problem of devising compensation rules that induce an agent
to act in the best interests of a principal. There are three ways of coping with this problem:
Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s
profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’
pay to the firm’s performance and helps align the managers’ and workers’ interests with those of
the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to
the long-term performance of the firm, encouraging the agents to work in the best long-term
interests of the firm owners, the principals.
3. What are the three types of firms? Explain the major advantages and disadvantages of each.
The three main ways of organizing a firm have both advantages and disadvantages:
• Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid;
and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are

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not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the
firm dies with the owner; and acquiring capital and labor is expensive.
• Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than
one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and
profits are taxed only once. DISADVANTAGES—all the owners’ wealth is at risk because of
unlimited liability; if there are many partners, gaining a consensus about managerial
decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs
are high compared to corporations; and capital costs can be high.
• Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available,
large-scale, and low-cost capital; can rely on professional managers rather than the talents of
the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially
complex management structure may lead to slow and expensive decision-making; and
profits are taxed twice, once as corporate profit and once as income to the stockholders.

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1. What are the four market types? Explain the distinguishing characteristics of each.
Economists identify four market types:
1. Perfect competition is a market with many firms, each selling an identical product. There are
many buyers and no restrictions on entry of new firms. Firms and buyers are all well
informed of prices and products of all firms in the industry.
2. Monopolistic competition is a market with many firms that produce similar but slightly
different goods.
3. Oligopoly is a market in which a small number of firms compete and each firm may produce
almost identical or differentiated goods.
4. Monopoly is a market in which only one firm produces the entire output of the industry.
There are no close substitutes for the monopolist’s product and there are barriers to entry
that protect the firm from competition of entering firms.
2. What are the two measures of concentration? Explain how each measure is calculated.
Two measures of concentration have been developed and are in common use: the four-firm
concentration ratio and the Herfindahl–Hirschman Index (HHI).
1. The four-firm concentration ratio is the percentage of the total industry sales accounted for
by the four largest firms in the industry.
2. The Herfindahl–Hirschman Index (HHI) equals the sum of the squared market shares of the
50 largest firms in the industry.
3. Under what conditions do the measures of concentration give a good indication of the
degree of competition in a market?
Concentration measures give a good indication of the degree of competition in a market if the
following characteristics of the industry market are correct:
1. The industry market is national in scope, rather than local or international.
2. There are no concerns about over-stating or under-stating the extent of barriers to entry.
3. Firms are not misclassified with respect to their markets.
4. Is the U.S. economy competitive? Is it becoming more competitive or less competitive?
The U.S. economy would be considered competitive since three-quarters of the value of goods
and services bought are in markets characterized as perfect competition or monopolistic
competition. The U.S. economy has become increasingly competitive over the decades.

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1. What are the two ways in which economic activity can be coordinated?
Firms and markets both coordinate resources.
2. What determines whether a firm or markets coordinate production?
Firms coordinate resources when they can do so at lower cost than can a market.
1. Firms may reduce transactions costs, which are the costs arising from finding someone with
whom to do business, reaching agreement on the price and other aspects of the exchange,
and ensuring that the terms of the agreement are fulfilled.
2. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as
its output rate increases.
3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a
range of different goods at a lower cost than otherwise.
4. Firms can engage in team production, in which the individuals specialize in mutually
supportive tasks.
Firms coordinate economic activity when they can perform a task more efficiently than markets
can. In such a situation, it is profitable to set up a firm. If markets can perform a task more
efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace
such market coordination will be doomed to failure.
3. What are the main reasons why firms can often coordinate production at a lower cost than
markets can?
Firms can often coordinate production at a lower cost than can markets because firms lower
transactions costs and achieve economies of scale, scope, and team production. These
opportunities are not present when markets coordinate production.

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Answers to the Study Plan Problems and Applications

1. One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following data
to calculate JJVB’s opportunity cost of production during its first year of operation:
• Jack and Jill put $50,000 of their own money into the firm and bought equipment for
$30,000.
• They hired one worker at $20,000 a year.
• Jack quit his old job, which paid $30,000 a year worked full-time for JJVB.
• Jill kept her old job, which paid $30 an hour, but gave up 500 hours of leisure a year to
work for JJVB.
• JJVB bought $10,000 of goods and services.
• The market value of the equipment at the end of the year was $28,000.
• Jack and Jill have a $100,000 home loan on which they pay interest of 6 percent a year.
The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are
opportunity costs to JJVB. Other opportunity costs include the interest forgone on the $50,000
put into the firm, which could have been used to pay part of the mortgage, so the interest forgone
is $3,000; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is
the value of 500 hours of Jill’s leisure; and the economic depreciation of $2,000 ($30,000 minus
$28,000). JJVB’s total opportunity cost is the sum of all these opportunity costs and is $80,000.
2. Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine
stand. Other operators of shoeshine stands earn $10,000 a year. Joe pays rent of $2,000 a
year, and his total revenue is $15,000 a year. Joe spent $1,000 on equipment, which he used
his credit card to buy. The interest on a credit card balance is 20 percent a year. At the end
of the year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s
opportunity cost of production and his economic profit.
Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest
paid on the $1,000 credit card balance; the $10,000 of normal profit; and, the $500 for the
depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes
minus the $500 he was offered for this equipment). Joe’s total opportunity cost is the sum of
these costs, which is $12,700. Joe’s economic profit is his total revenue, $15,000, minus his total
opportunity cost, $12,700, for an economic profit of $2,300.
3. Four ways of laundering 100 shirts are in the table. Labor Capital
a. Which methods are technologically efficient? Method (hours) (machines)
All the methods are technologically efficient. A 1 10
b. Which method is economically efficient if the hourly B 5 8
wage rate and the implicit rental rate of capital are: C 20 4
(i) Wage rate $1, rental rate $100? D 50 1
Method D is economically efficient because the total
cost is the least. Method D’s costs are 50  $1 + 1  $100, or $150.
(ii) Wage rate $5, rental rate $50?
Method D and Method C are economically efficient because the total cost is the least. Method
C’s costs are 20  $5 + 4  $50, or $300 and Method D’s costs are 50  $5 + 1  $50, also $300.
(iii) Wage rate $50, rental rate $5?
Method A is economically efficient because the total cost is the least. Method A’s costs are 1 
$50 + 10  $5, or $100.

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4. CEO Pay Is Rising Twice as Fast as Workers’ Income

Executive compensation, in salary, stock, and other compensation, increased 8.5 percent in
2016 to a median of $11.5 million. It’s the biggest CEO pay increase in three years.
Source: time.com/money, May 23, 2017
What is the economic problem that CEO compensation schemes are designed to solve?
Would paying executives with stock align their interests with shareholders’?
CEO compensation schemes are designed to overcome the principal-agent problem. A CEO’s
decisions can have large effects on the company’s profitability. The principals, the shareholders
of the corporation, want the CEO, the agent, to carefully consider the decisions and make
decisions that boost the firm’s profit. The CEO, however, has the incentive to shirk and to make
decisions that boost his or her well-being rather than the company’s profit.
Paying executives with stock helps align their interests with shareholders. If the profit rises, then
the company’s stock price will rise. If the CEO’s pay is largely determined by changes in the stock
price, then the CEO’s decisions are directly linked to the company’s fortunes.
5. Sales of the firms in the tattoo industry are in the
table. Calculate the four-firm concentration ratio. Sales
What is the structure of the tattoo industry? (dollars
The four-firm concentration ratio is 60.49. The four- Firm per year)
firm concentration ratio equals the ratio of the total Bright Spots 450
sales of the largest four firms to the total industry sales Freckles 325
expressed as a percentage. The total sales of the largest Love Galore 250
four firms is $450 + $325 + $250 + $200, which equals Native Birds 200
$1,225. Total industry sales equal $1,225 + $800, which Other 15 firms 800
equals $2,025. The four-firm concentration ratio equals
($1,225/$2,025)  100, which is 60.49 percent.
This industry is highly concentrated because the four-firm concentration ratio exceeds 60
percent.
6. Walmart, Grocery, Target Top Personal Care Market Share
A Personal Care Study conducted by TABS Analytics shows that Walmart has a 19.4 percent
share of the $40 billion personal care market, while grocery stores Kroger and Publix have
a 16.6 percent share, and Target, 12.8 percent.
Source: drugstorenews.com, March 23, 2017
Estimate a range for the four-firm concentration ratio and the HHI for the U.S. personal care
market based on the data provided in this news clip.
Walmart has the largest market share, 19.4 percent, and Kroger and Publix are tied for the
second largest market share, 16.6 percent. Target is fourth with a market share of 12.8 percent.
Consequently, the four-firm concentration ratio equals 19.4 + 16.6 + 16.6 + 12.8 which is ranges
from 65.4 percent.
The HHI equals the sum of the squared market shares of the 50 largest firms. Wal-Mart’s
contribution to the HHI is 19.42 which is 376.4; Kroger’s and Publix’s contributions to the HHI is
each 16.62 which is 275.6; and, Target’s contribution is 12.82 which is 163.8. If there are two
other firms each with a market share of 12.7 percent and one other firm with a market share of
9.2 percent, the HHI attains its maximum of 1,498.6. If there are 36 other firms each with a
market share of 1 percent, the HHI 19.42 + 16.62 + 16.62 + 12.82 + 36×12 = 1127. So the HHI can
range from about 1,127 to about 1,500.
7. FedEx contracts with independent truck operators to pick up and deliver its packages and

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pays them on the volume of packages carried. Why doesn’t FedEx buy more trucks and hire
more drivers? What incentive problems might arise from this arrangement?
FedEx does not buy more trucks and hire more drivers because FedEx faces a principal-agent
problem. In particular, it is not easy to monitor its drivers and insure that they are working hard
to efficiently deliver packages. FedEx overcomes this problem by hiring independent contractors
and then paying them based on the amount of packages they deliver. Essentially, FedEx uses a
piecework method of payment.
FedEx pays its drivers based on the volume of packages they deliver. This method of payment
creates a few incentive potential problems for FedEx. First, FedEx must worry about the quality
of its service. In particular, unless FedEx bases part of the payment on quality, its drivers have an
incentive to drop the package and race off to the next delivery with no concern for how the
packages are handled. Second, FedEx must take care that drivers do not attempt to select only
packages that are close to the FedEx location and avoid packages that have a greater than
average driving time. Finally, FedEx also must worry that its drivers do not take undue risks
while driving in order to deliver as many packages as possible. If FedEx trucks were involved in
too many accidents, FedEx would suffer bad publicity and, presumably, would lose some
business.

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Answers to Additional Problems and Applications

Use the following data to work Problems 8 and 9.
Lee is a computer programmer who earned $35,000 in 2016. But on January 1, 2017, Lee opened
a body board manufacturing business. At the end of the first year of operation, he submitted the
following information to his accountant:
• He stopped renting out his cottage for $3,500 a year and used it as his factory. The market
value of the cottage increased from $70,000 to $71,000.
• He spent $50,000 on materials, phone, etc.
• He leased machines for $10,000 a year.
• He paid $15,000 in wages.
• He used $10,000 from his savings account, which earns 5 percent a year interest.
• He borrowed $40,000 at 10 percent a year.
• He sold $160,000 worth of body boards.
• Normal profit is $25,000 a year.
8. Calculate Lee’s opportunity cost of production and his economic profit.
Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid
for the machine lease; $4,000 paid for interest expense on the loan; $3,500 of forgone rent for
the cottage plus −$1,000 for the “depreciation” of the cottage (the cottage actually appreciated);
$500 in forgone interest from the savings account; wages forgone of $35,000; and, $25,000 for
normal profit. These give a total opportunity cost of $142,000. Lee’s economic profit is the total
revenue, $160,000, minus the total opportunity cost, $142,000, for an economic profit of
$18,000.
9. Lee’s accountant recorded the depreciation on his cottage during 2017 as $7,000.
According to the accountant, what profit did Lee make?
Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for
wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; and,
$7,000 of depreciation expense for a total opportunity cost of $86,000. The total profit according
to the accountant will equal total revenue, $160,000, minus total cost, $86,000, for a profit of
$74,000.
10. In 2016, Toni taught music and earned $20,000. She also earned $4,000 by renting out her
basement. On January 1, 2017, she quit teaching, stopped renting out her basement, and
began to use it as the office for her new Web site design business. She took $2,000 from her
savings account to buy a computer. During 2017, she paid $1,500 for the lease of a Web
server and $1,750 for high-speed Internet service. She received a total revenue from Web
site designing of $45,000 and earned interest at 5 percent a year on her savings account
balance. Normal profit is $55,000 a year. At the end of 2017, Toni could have sold her
computer for $500. Calculate Toni’s opportunity cost of production and her economic profit
in 2017.
Toni has costs of $1,500 for the lease of a Web server; $1,750 for high-speed Internet service;
$55,000 for normal profit; $20,000 of forgone earnings from teaching; $4,000 of forgone rent
from renting her basement; $100 of forgone interest from her saving account; and $1,500 for the
depreciation of her computer (which equals the $2,000 paid for it minus the $500 for which she
could have sold it). These various costs sum to a total opportunity cost of $83,850. Toni’s
economic profit is her total revenue, $45,000, minus her total opportunity cost, $83,850, for an
economic loss of $38,850.

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11. Starburst “All Pink” Packs Show Importance of Giving Customers What They Want
Giving customers what they want, Starburst candy will produce limited edition bags of “All
Pink”
Source: smallbiztrends.com, Mar 10, 2017
a. Does the news clip imply that Starburst’s goal is customer satisfaction and not profit
maximization?
Although the news clip talks about customer satisfaction, Starburst’s actual focus is on its profit.
If Starburst produced products consumers did not want, no one would buy its candy so Starburst
would shut down. By producing candy that customers want, Starburst will make a profit and stay
in business.
b. What would happen to Starburst if it didn’t focus on maximizing profit, but instead
focused its production and pricing decisions to “give customers what they want”?
In general customers want very tasty, potentially very costly candy sold for an exceptionally low
price. In particular, customers want to pay the lowest price possible regardless of the company’s
profit. If Starburst focused on only giving customers want they want, Starburst would incur a
loss and ultimately would either close or be purchased by another company.
12. Investing in Watches
The values of premium second-hand watches have been rising and a Luxury Investment
Index says they are expected to appreciate 68 percent over 10 years. But investing in
watches is risky. Their prices don’t always rise.
Source: New York Times, September 29, 2015
a. What is the cost of buying a watch?
The (opportunity) cost of buying a watch is the loss of whatever else would have been purchased
with the funds.
b. What is the opportunity cost of owning a watch?
The opportunity cost of owning a watch is the annual forgone return, such as the forgone
interest from buying a watch rather than placing the funds in a savings account, and the
depreciation of the watch.
c. Does owning a watch create an economic profit opportunity?
Yes, owning a watch creates an economic profit opportunity. If the watch appreciates at a rapid
clip, so that the gain in the value of the watch over time exceeds the normal profit from the funds
used to purchase the watch, then owning the watch has lead to an economic profit.
Use the following data to work Problems 13 and 14.
Four methods of completing a tax return and the time taken by each method are: with a PC, 1
hour; with a pocket calculator, 12 hours; with a pocket calculator and paper and pencil, 12 hours;
and with a pencil and paper, 16 hours. The PC and its software cost $1,000, the pocket calculator
costs $10, and the pencil and paper cost $1.
13. Which, if any, of the methods is technologically efficient?
All methods other than “pocket calculator with paper and pencil” are technologically efficient. To
use a pocket calculator with paper and pencil to complete the tax return is not a technologically
efficient method because it takes the same number of hours as it would with a pocket calculator
but it uses more capital.

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14. Which method is economically efficient if the wage rate is

(i) $5 an hour?
The economically efficient method is the technologically efficient method that allows the task to
be done at least cost. When the wage rate is $5 an hour, total cost with a PC is $1,005, total cost
with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least
with a pocket calculator.
(ii) $50 an hour?
When the wage rate is $50 an hour, total cost with a PC is $1,050, total cost with a pocket
calculator is $610, and the total cost with paper and pencil is $801. The pocket calculator is
economically efficient.
(iii) $500 an hour?
When the wage rate is $500 an hour, total cost with a PC is $1,500, total cost with a pocket
calculator is $6,010, and total cost with pencil and paper is $8,001. The PC is economically
efficient.
15. Would You Let a Robot Perform Your Surgery?
A recent study showed that an autonomous robot can perform soft-tissue surgery, and do
so better than a human surgeon.
Source: CNN, May 12, 2016
a. Assume that performing a surgery with a surgical robot requires fewer surgeons and
nurses. Is using the surgical robot technologically efficient?
Using the surgical robot is technologically efficient because the production technique uses less
labor (and more capital) than the non-robotic technique.
b. What additional information would you need to be able to say that switching to surgical
robots is economically efficient for a hospital?
To determine if the production technique is economically efficient, information about the cost of
the robot and the cost of the nurses and doctors and about the number of doctors and nurses
each production technique uses is needed.
16. Wal-Mart has more than 3,700 stores, more than one million employees, and total revenues
of close to a quarter of a trillion dollars in the United States alone. Sarah Frey-Talley runs
the family-owned Frey Farms in Illinois and supplies Wal-Mart with pumpkins and other
fresh produce.
a. How does Wal-Mart coordinate its activities? Is it likely to use mainly a command system
or also to use incentive systems? Explain.
Wal-Mart is a huge organization. As such, it uses both command and incentive systems. At the
lower, store level, command is the system that is most commonly used. (For instance, an
associate is told that he or she will help unload a delivery and stack the packages against the
South wall.) At the higher, corporate level, incentive is the system most commonly used. (For
instance, regional directors have part of their income tied to their region’s performance.)
However, even at the store level some incentive systems are used (associates can enroll in a
profit sharing plan) and even at the corporate level some command systems are used (regional
directors are told that they must report to their supervisors on a weekly basis).
b. How do you think Sarah Frey-Talley coordinates the activities of Frey Farms? Is she likely
to use mainly a command system or also to use incentive systems? Explain.
Ms. Frey-Talley probably uses a command system significantly more often than an incentive
system. Her farm has few employees and so it is easy to tell each employee what to do, when to

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do it, and where to do it. Possibly the only use of an incentive system might be if Ms. Frey-Talley
has some higher-ranking family members on a profit-sharing program.
c. Describe, compare, and contrast the principal–agent problems faced by Wal-Mart and
Frey Farms. How might these firms cope with their principal–agent problems?
Wal-Mart faces many more principal-agent problems than does Ms. Frey-Talley. For Ms. Frey-
Talley’s farm, it is relatively straightforward to monitor each employee so employees will find it
difficult to shirk. Plus Ms. Frey-Talley owns the farm herself, and so there is no principal-agent
problem associated with a difference between the owners and the managers. Wal-Mart,
however, has more than one million employees. Each of these employees realizes that if he or
she shirks, it will make little difference to Wal-Mart’s overall performance. So Wal-Mart’s
managers must be constantly alert to this problem. Wal-Mart also faces the principal-agent
problem that results because its owners are not its managers. As a result, the owners must try to
create incentives for the managers to behave in the best interests of the owners. Wal-Mart has a
number of ways that it can try to overcome the principal-agent problems it faces. Its top
management is given stock options. Regional managers, store managers, and top level store
management are given profit-sharing packages that depend on the performance of the region or
a particular store. Buyers for Wal-Mart—people employed by Wal-Mart to determine which
products Wal-Mart will purchase—are often given profit-sharing packages that increase the
buyer’s income depending on how well the products the buyer purchased perform in the stores.
All of these are designed to give the recipient the incentive to make decisions that boost Wal-
Mart’s profit and thereby its stock price, which benefit the owners.
17. Where Does Google Go Next?
Google gives its engineers one day a week to work on whatever project they want. A couple
of colleagues did what many of the young geniuses do at Google: They came up with a cool
idea. At Google, you often end up with a laissez-faire mess instead of resource allocation.
Source: Fortune, May 26, 2008
a. Describe Google’s method of organizing production with their software engineers.
In some sense Google is using a command system because Google “orders” its engineers to use
one day a week to work on their own projects. But in a larger sense Google is using an incentive
system. If one of the engineers comes up with a wildly profitable idea, the engineer will benefit
by gaining stature and probably income within Google.
b. What are the potential gains and opportunity costs associated with this method?
The potential gain is that the creative people working for Google will apply their creativity to
develop new and better products for Google. The potential drawback is the principal-agent
problem. The engineers might use their time for on-the-job leisure rather than for new, cutting
edge research.
18. Market shares of chocolate makers are in the table.
Market
Calculate the Herfindahl-Hirschman Index. What is the Firm share
structure of the chocolate industry? (percent)
The Herfindahl-Hirschman Index is 1,800. The
Truffles, Inc. 25
Herfindahl-Hirschman Index equals the sum of the
squares of the market shares of the 50 largest firms or
Magic, Inc. 20
of all firms if there are less than 50 firms. The Mayfair, Inc. 15
2
Herfindahl-Hirschman Index equals 15 + 10 + 20 +
2 2 All Natural, Inc. 15
2 2 2
15 + 25 + 15 , which equals 1,800.
Gold, Inc. 15
This industry is moderately concentrated because the Bond, Inc. 10
Herfindahl-Hirschman Index lies in the range 1,500 to 2,500.

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148 CHAPTER 10

Use the following information to work Problems 19 to 21.

Two leading design firms, Astro Studios of San Francisco and Hers Experimental Design
Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game
console. IBM, ATI, and SiS designed the Xbox 360’s hardware. Three firms—Flextronics, Wistron,
and Celestica—manufacture the Xbox 360 at their plants in China and Taiwan.
19. Describe the roles of market coordination and coordination by firms in the design,
manufacture, and marketing of the Xbox 360.
Microsoft entered the market to hire various firms, Astro Studios and Hers Experimental Design
Laboratory to design the Xbox 360 and then entered the market again to hire IBM, ATI, and SiS to
design the hardware of the Xbox 360. Finally, Microsoft once again entered the market to hire
Flextronics, Wistron, and Celestica to produce the Xbox 360. Once Microsoft had contracted with
these firms, the design, manufacture, etc. takes place within the firm.
20. a. Why do you think Microsoft works with a large number of other firms, rather than
performing all the required tasks itself?
Microsoft works with a large number of firms rather than doing everything in-house because it is
less expensive for Microsoft to work with other firms. These other firms have specialized in
various tasks and so have gained economies of scale that Microsoft does not possess. Therefore it
is cheaper for Microsoft to enter the market and hire the expertise it needs than to do it all itself.
b. What are the roles of transactions costs, economies of scale, economies of scope, and
economies of team production in the design, manufacture, and marketing of the Xbox?
Microsoft needed to determine what part of designing, building, and marketing the Xbox would
take place inside of Microsoft and what would take place in other companies that Microsoft
hired. Hiring other companies means that Microsoft incurs the transactions costs of using
markets. However, other companies that specialized in different tasks have economies of scale,
economies of scope, and/or economies of team production that lower the cost to Microsoft of
hiring them. So Microsoft had to determine which parts of the Xbox 360 would be cheaper to
undertake inside of Microsoft and which parts would be cheaper to enter the market to contract
with other firms.
21. Why do you think the Xbox is designed in the United States and Japan but built in China?
The Xbox is designed in America and Japan because America and Japan have a large number of
highly-skilled workers who can successfully design the Xbox. With a large number of technically
adept workers, it is less expensive to design the Xbox in these countries. Manufacturing the Xbox,
however, takes place in China because China has a large number of lower-skilled workers and so
it is less expensive to build the Xbox in China.

Economics in the News

22. After you have studied Economics in the News on pp. 244–245, answer the following
questions.
a. What products do Facebook and Google sell?
Facebook sells social networking services; that is, it allows its users to keep up with their friends.
Google sells search services; that is, it helps its users search the Internet for the topics in which
they are interested.
b. In what types of markets do Facebook and Google compete?
Both markets have other providers of similar services. But in each case there are a few that are
much larger than the other competitors. So both markets are oligopolies.

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 ORGANIZING PRODUCTION 149

c. How do social networks and Internet search providers generate revenue?

Both social network Internet sites and Internet search providers generate revenue from sale of
advertisements.
d. What is special about social network sites that make them attractive to advertisers?
Social network sites have millions of users. Users typically provide the social network site
information about the user’s interests. Therefore these sites are attractive to advertisers because
an advertiser gains a large audience of people who have a tendency to be interested in the
advertiser’s product.
e. What is special about Internet search providers that make them attractive to advertisers?
Users of Internet search providers often are searching for either a particular product or else a
product to fill a particular need. Often users are searching with an intention to buy. Advertisers
are attracted to these web sites because they allow the advertiser to target an audience that is
frequently going to purchase the product the advertiser has for sale.
f. What technological changes might increase the profitability of social networks compared
to Internet search providers?
Technological change that enables the social networking site to more precisely target the
preferences of individual consumers—such as past buying history from the social networking
website or better information about preferences via the consumer’s past web browsing on the
social network site or on other web sites—would make Internet advertising on the social
website more profitable because the ads would more precisely reflect the potential buyer's
interests. This change would enable the social networking website to set a higher price for each
advertisement, thereby increasing its profitability compared to Internet search providers.
23. Effects of Merit Pay For Teachers
An experiment that awarded teachers higher pay if their students’ test results were higher
suggests that the bonuses didn’t simply lead teachers to teach to the test, but provided their
students with knowledge and work habits that served them well later in life.
Source: The Washington Post, March 16, 2015
How does merit pay for teachers attempt to cope with the principal–agent problem in
public education? Does the information in the news clip suggest that it works?
The principal-agent problem with teachers in public education is the concern that teachers will
not work hard in the classroom. Teachers’ efforts are difficult to monitor and so teachers have
the incentive to shirk by working less diligently and teaching their students less. Merit pay is an
incentive system that links the teachers’ pay to their students’ achievement, in the case at hand,
performance on standardized exams. With this linkage teachers will be paid more the better
their students’ performance which gives the teachers the self-interested incentive to work
diligently to instruct their students. According to the results from this experiment, merit pay
worked because students gained knowledge and work habits that benefited them in later life.

© 2018 Pearson Education, Inc.