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Test 1 2010 fall

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University of Toronto Mississauga
Robert Barber

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
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