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Midterm

Test 1 2010 fall

7 Pages
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Department
Economics
Course Code
ECO370Y5
Professor
Robert Barber

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ECO 370
Economics of Organization
Test I ± Solution Outline
Friday, November 26, 2010
10:10 AM to 12:00 PM ± NB 263
______________________________________________________________________
Question 1,3,5 Suppose there are two firms, A and B. These firms decide to make a joint
investment in a project. The total revenue from the project is 200(VA + VB)(1/2)
which A and B agree to share equally. VA is the value and the cost of the
investment Firm A makes. VB is the value and the cost of the investment Firm B
makes.
5 (a) State and explain the principle of value maximization
³)RUDQ\LQHIILFLHQWDOORFDWLRn, there exists another (total value
PD[LPL]LQJDOORFDWLRQWKDWDOORIWKHSDUWLHVVWULFWO\SUHIHU´
[Milgrom and Roberts ± pp. 35 - 36]
The objective of both the principal and the agent in establishing a
contract is to maximize the welfare or social surplus of the organization
Only when the value maximization principle applies is there an objective
that one can ascribe to an organization implied by efficiency.
5 (b) Show that the value maximizing total investment of firms A and B is $10,000
when each firm can observe the investment of the other firm.
Total Surplus = 200(VA + VB)(1/2) ± VA - VB
dS/dVA = 100(VA + VB)(-1/2) ± 1 = 0
dS/dVB = 100(VA + VB)(-1/2) ± 1 = 0
10,000 = (VA + VB)
5,000 = VA = VB
Total Surplus* = 200(10,000)(1/2) ± 10,000 = 10,000
5 (c) Suppose each firm cannot observe the investment of the other firm. Show that
if Firm A expects Firm B to invest VB (which Firm A cannot observe) then the
optimal amount Firm A will invest is VA = $2,500 - VB.
Since A cannot see what B invests, Firm A will take VB as given and
maximize its profit
Profit = SA = 100(VA + VB)(1/2) ± VA
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First Order Condition
dSA/dVA = 50(VA + VB)(-1/2) ± 1 = 0
50(VA + VB)(-1/2) = 1
50 = (VA + VB)(1/2)
2,500 = (VA + VB)
VA = 2,500 - VB
5 (d) When each firm cannot observe the investment of the other firm, what is total
surplus?
Since VA + VB = 2,500, this is the total investment
Total Surplus* = 200(2,500)(1/2) ± 2,500 = 7,500
Question 2,4,6 Describe and explain what went wrong at Salomon Brothers and what plan
was implemented
10
Salomon Brothers was a major investment bank on Wall Street
Salomon Brothers originally had a performance pay system involving a
base salary and an annual bonus
7KLVV\VWHPHIIHFWLYHO\HQFRXUDJHG6DORPRQ¶VHPSOR\HHVWRZRUN
extremely hard and to take great risks to increase both their own and
WKHLUGHSDUWPHQWV¶SURILWV
Salomon Brothers performance pay system discouraged the exchange of
information between departments
So this plan did not encourage cooperation between departments ±
VRPHWLPHVWKHUHZHUHDWWHPSWVWR³VWHDO´RWKHUGHSDUWPHQWV¶SURILWV
Negative effect on profits
The new plan was a bonus scheme which included a trust for the
employee, who would not be able to withdraw it for five (5) years, tying
the value of each bonus to the overall market value of the firm five (5)
years in the future
This was WRHQVXUHWKDWHPSOR\HHVZLOOEHFRQFHUQHGZLWKWKHILUPs long-
run performance
[Milgrom and Roberts ± pp. 9 - 12]
Question 3,5,1(a) What is the efficiency problem and identify the two (2) main components
of this problem
5
x When individuals are indifferent about some of the available choices,
then a choice is efficient if there is no other available option that
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Description
ECO 370 Economics of Organization Test I Solution Outline Friday, November 26, 2010 10:10 AM to 12:00 PM NB 263 ______________________________________________________________________ Question 1,3,5 Suppose there are two firms, A and B. These firms decide to make a joint (12) investment in a project. The total revenue from the project is 2A0(V +BV ) which A and B agree to share equally. VAis the value and the cost of the investment Firm A makes. V iB the value and the cost of the investment Firm B makes. 5 (a) State and explain the principle of value maximization 47,3L3011L.L039,OO4.,9L4n, there exists another (total value 2,[L2L]L3J ,OO4.,9L439K,9,OO419K05,79L08897L.9O570107 [Milgrom and Roberts pp. 35 - 36] The objective of both the principal and the agent in establishing a contract is to maximize the welfare or social surplus of the organization Only when the value maximization principle applies is there an objective that one can ascribe to an organization implied by efficiency. 5 (b) Show that the value maximizing total investment of firms A and B is $10,000 when each firm can observe the investment of the other firm. Total Surplus = 200(V +AV ) B (1 V A V B (-12) dSdV =A100(V + A ) B 1 = 0 dSdV =B100(V + A ) B(-1 1 = 0 10,000 = (V + V ) A B 5,000 = V A V B Total Surplus* = 200(10,000) (1 10,000 = 10,000 5 (c) Suppose each firm cannot observe the investment of the other firm. Show that if Firm A expects Firm B to invest B (which Firm A cannot observe) then the optimal amount Firm A will invest is VA= $2,500 - V B Since A cannot see what B invests, Firm A will take V Bs given and maximize its profit Profit = 5A = 100(V A V )B (12 VA www.notesolution.com
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