Deck 10: Incentive Conflicts and Contracts

Question 1

Mary Jo Smith is willing to work for $3,200 per month. She asks the HR manager at Plain Truth Advertising for $4,000 per month. While he was willing to pay $3,700 per month, he rejects her application and begins to search for a new employee again. This is an example of:

A) adverse selection.
B) value maximization.
C) bargaining failure.
D) agency incentive problems.

Answer 1

C

Question 2

An informal understanding about the quality of product components is a key to the relationship between most companies and their suppliers. This a good example of:

A) an implicit contract.
B) an explicit contract.
C) a principal/agent conflict resolution.
D) an adverse selection problem.

Answer 2

A

Question 3

A pilot for a private jet stops for refueling in Omaha, Nebraska. Topper Fuels offers him a case of French wine to refuel with them (a total retail value of $324 to the pilot). For refueling, inspections, and minor repairs, Topper charges $2,700, $400 more than the least expensive fuel company. What has happened to the company that owns the private jet?

Answer 3

This is an example of an incentive conflict that is only possible because of asymmetric information. The owner of the private jet knows much less about the price of refueling in this market than the pilot that was hired. The pilot can take advantage of this in order to pick the refueling company that offers the pilot, not the owner of the private jet, the best deal. The combined welfare of the pilot and owner of the private jet is lower by $76 because while the pilot to $324 better off from the wine, the owner of the jet is $400 worse off.

Question 4

Billy Mac Tailor drives an eighteen-wheeler CG Carriers. He always stops at All Bright truck stops to by diesel fuel. He is a preferred customer and gets a free meal and shower worth $10.00. But All Bright charges $12.00 more for a fill up than most competitors. Which of the following is true?

A) CG Carriers gets a benefit of $22.00 because Tailor is a preferred customer.
B) CG Carriers has a wealth reduction of $2.00 even though they do not know about Tailor's actions.
C) There is a wealth transfer to Billy Mac Tailor and CG Carriers has a wealth reduction of $12.00 .
D) Billy Mac Tailor increases his income by $10.00 and CG Carriers also benefits.

Question 5

Adverse selection in bargaining comes from:

A) lying to one party or another.
B) principals in the bargaining process.
C) agents in the bargaining process.
D) asymmetric information held by the principal or agent.

Question 6

Always Round Tire hires Plain Truth Advertising to write copy for its newspaper advertisements. Always Round has a demand for advertising of MB = 400 -2S where S is the number of hours that Plain Truth delivers. If Plain Truth has a fixed supply cost: MC = $150 per hour, what are the number of hours that Always Round purchases from Plain Truth under the assumption of costless monitoring? How much is the contract worth to Always Round? If Always Round offers half of the surplus to Plain Truth as an incentive, how much is Plain Truth paid for the job?

Question 7

A firm is focal point for a set of contracts. Explain the problems that (1) agency relationships, (2) asymmetric information, and (3) adverse selection can introduce to building a successful contract between two people.

Question 8

What is an agency relationship? What are agency problems?

Question 9

What are some ways of reducing adverse selection in the insurance market?

Question 10

J.T. Smith's company, Gamemaker, sells gambling equipment to gaming service companies. Since the quality of the equipment is difficult to monitor and gamblers are often the source of machine failure, Smith could cheat on the level of machine quality. However, Smith has a strong quality assurance program. A primary reason for that may be:

A) cost containment.
B) company reputation.
C) the need for reinforcement.
D) the asymmetric information Smith holds on quality.

Question 11

J.T. Smith runs Gamemaker, an equipment producer for gaming service corporations. As CEO, Smith is seemingly worth $2.5 million per year in the marketplace. The directors are attempting to decide how to divide his compensation package between cash salary and perquisites. Using budget constraints and indifference curves, illustrate the potential outcomes for the Board of Directors.

Question 12

What is Adverse Selection? Give an example to illustrate this problem.

Question 13

Jim Range owns a Best Ice Cream store, one of 1,000 franchises across the country. Jim doesn't like to work evenings, so he hires Mary Jo Smith to work the store in the evening for $6.50 per hour. Mary Jo's friends come by each evening and she gives them free cones. Is this an adverse selection problem or an incentive problem? What is the solution?

Question 14

Always Round Tire hires Plain Truth Advertising to write copy for its newspaper advertisements. Always Round has a demand for advertising of MB = 400 -2S where S is the number of hours that Plain Truth delivers. If Plain Truth has a fixed supply cost: MC = $150 per hour, what are the number of hours that Always Round purchases from Plain Truth? Now, if the copy writers are slackers and only deliver 100 hours of work each week, and if the each company must spend $1,250 in monitoring and bonding costs, what is the surplus and residual loss in this environment?

Question 15

While many managers and lawyers might claim that implicit contracts "aren't worth the paper that they are not written on," most understandings between companies and their customers and their employees are implicit. Why?

Question 16

While CEO of General Electric, Jack Welch was a very successful corporate manager. He also loaded up his retirement program with numerous unusual benefits such as rented apartments, free airplanes, and numerous club memberships. The owners (stockholders) were generally unaware of these benefits. This conflict between owners and managers involved:

A) choice of effort of Mr. Welch while he was CEO.
B) perquisite taking on the part of Mr. Welch.
C) differential risk exposure between Mr. Welch and the typical stockholder.
D) overinvestment in company offices by Mr. Welch.

Question 17

Incentive problems can be overcome, then it is in the interest of all parties to develop efficient solutions to agency problems. Through ______ , there will be more wealth to be shared among contracting parties.

A) adverse selection
B) value maximization
C) contracting until marginal benefit (MB) equals zero
D) asymmetric information

Question 18

Kaneshi Hartfield is a sales representative with Plain Truth Advertising. She is an excellent sales representative, but corporate management feels that she is too independent. But they are afraid to act, since Kaneshi maintains her own list of key contacts. This is an example of:

A) asymmetric information problems.
B) different time horizons of the sales representative and management.
C) the free rider problem.
D) the failure of bargaining.

Question 19

Which of the following is not a problem in owner/manager (principal/agent) conflicts?

A) Choice of effort.
B) Perquisite taking.
C) Identical time horizons.
D) Differential risk exposure.

Question 20

Monitoring costs are:

A) the costs of a failure in bargaining.
B) rarely incurred in contracts between a principal an agent.
C) the insurance costs of guaranteeing that the principal will not incur a cost of contract failure.
D) the costs of reviewing and overseeing the actions of an agent.

Question 21

Which one of the following is a source of conflict between owners and managers?

A) Manager's effort leaves firm's value and manager's utility unchanged.
B) Manager's effort decreases firm's value and manager's utility.
C) Manager's effort increases firm's value but decreases manager's utility.
D) Manager's effort increases firm's value and manager's utility.

Question 22

Designing efficient contracts are costly when:

A) the monitoring costs are low for the agent.
B) the monitoring costs are low for the principal.
C) there are huge monitoring costs for the principal.
D) there are huge monitoring costs for the agent.

Question 23

You want to hire a law firm to represent you from which you derive benefit. The law firm incurs costs from providing this service. As long as marginal benefits are greater than marginal costs:

A) Value is minimized.
B) Value is not maximized because too much services is provided.
C) Value is not maximized because services are not sufficient.
D) Value is maximized.

Question 24

FancyFoods restaurant decided to introduce an all-you-can-eat buffet on Tuesdays and Wednesdays to increase business. They found that they acquired a whole new set of customers, most of whom are very big eaters. After a time, they increased the price of buffet. FancyFoods suffered from the problem of:

A) excessively high costs.
B) adverse selection.
C) the law of demand.
D) the principal agent problem.

Question 25

Often people in business work in teams, each using specialized knowledge to get the tasks done. If one member of the team does no work, this is called:

A) the reward system.
B) adverse selection.
C) free riding.
D) performance evaluation.

Question 26

Which one of the following is a source of conflict between owners and managers?

A) What the owners and the managers want to pay.
B) What the owners and the managers want to receive.
C) What the owners want to pay and what the managers want to receive.
D) What the owners want to receive and what the managers want to pay.

Question 27

In most models of managerial conflict, the owner is the ________ and the manager is the __________.

A) wage earner; stockholder
B) employee; director
C) principal; agent
D) resource; resource owner

Question 28

Which one of the following is a source of conflict between owners and managers?

A) Managers are often reluctant to increase the size of the firm.
B) Owners are reluctant to lay off the manager and want to empire-build.
C) Managers are reluctant to lay off their friends and want to empire-build.
D) Owners are reluctant to lay off their friends and want to empire-build.

Question 29

Which one of the following is a source of conflict between owners and managers?

A) Managers and owners have a very short time horizon.
B) Managers and owners worry about the entire future cash flows.
C) Managers have very short time horizon; owners worry about the entire future cash flows.
D) Owners have very short time horizon; managers worry about the entire future cash flows.

Question 30

Which one of the following is a source of conflict between owners and managers?

A) Managers and owners are both highly risk-averse.
B) Managers and owners are both risk-takers.
C) Managers are more risk-averse whereas owners are not.
D) Managers are less risk-averse whereas owners are not.

Question 31

It is in the self interest of individuals to:

A) minimize the total contracting costs in any relationship.
B) maximize the total contracting costs in any relationship.
C) eliminate the total bargaining costs in any relationship.
D) reduce value through formal contracting costs.

Question 32

Which one of the following is a big problem in large groups?

A) Useless group leader.
B) Adverse selection problem.
C) Free-rider problem.
D) Buyer-supplier conflicts.

Question 33

Designing efficient contracts are costly when:

A) everyone wants to cheat anyway.
B) there is complete information.
C) there is asymmetric information.
D) there is a free-rider problem.

Question 34

The firm or corporation is the focal point for a set:

A) explicit contracts.
B) informal contracts.
C) implicit contracts.
D) All of the above.

Question 35

Incentive problems in contractual relationships generate:

A) revenues that increase value.
B) revenues that decrease value.
C) costs that increase value.
D) costs that decrease value.

Question 36

Joan Petty, a human resource manager, offers Billy Self $2,750 per month as an inventory manager. She is willing to offer $750 more per month, but Billy does not have that information and walks away from the job offer. This is an example of a:

A) market at work.
B) bargaining success.
C) bargaining failure.
D) market in transition.

Question 37

Using piece rates for employees in an assembly line usually increases ________, but it may reduce ________.

A) output; quality
B) costs; revenues
C) quality; output
D) revenues; costs

Question 38

Total agency costs are:

A) the monitoring costs plus residual loss.
B) the monitoring costs plus out of pocket costs.
C) out of pocket costs plus residual loss.
D) out of pocket costs minus residual loss.

Question 39

Markets use prices to allocate resources; firms use:

A) cost-price ratios.
B) managers.
C) the Board of Directors.
D) random decisions.