UNIVERSITY OF ROCHESTER

WILLIAM E. SIMON GRADUATE SCHOOL OF

BUSINESS ADMINISTRATION

STR 403
Economic Theory
Of Organizations
Winter, 2009
Assistant: Kate Walsh

Professor Gerard Wedig

Office: CS3 160J
Phone: 273-1647
Email: [email protected]

MIDTERM EXAMINATION ANSWERS

Mean: 41.4
Standard Deviation: 8.8

Name____________________________________
1) This is a closed book, closed note exam.
2) The clarity and succinctness of your answers are crucial. Think first and use a
well structured approach to answering each question. Neither I nor the graders are
obligated to search for the correct answer in the midst of unrelated or incorrect
material.
3) All answers should be completed in the space provided
4) Most or all of the questions can be answered with just a few carefully selected
sentences.
Question 1 (10 Pts.)

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Question 2 (10 Pts.)

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Question 3 (10 Pts.)

____________

Question 4 (10 Pts.)

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Question 5 (10 Pts.)

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Question 6 (10 Pts.)

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Total ___________

1. Economic Man (10 Pts.)

In the Wall Street Journal (WSJ) edition of Tuesday, February 10th, 2009, it was reported
that car accident deaths in the U.S. fell in 2008. Moreover, the article also reported that
the death rate also fell per mile driven.
The WSJ article goes on to say that gasoline prices were significantly higher in 2008 than
in past years and that most automobiles achieve their best gas mileage at speeds
between 30 MPH and 60 MPH. Finally, assume that fatalities are generally associated
with high rates of speed, often in excess of 75MPH.
a. (4 Pts.) Use the economic model of behavior to offer an explanation for how the
rise in gas prices could have lead to a reduction in mortality per mile driven in
2008. Be sure to mention relevant key assumptions of the economic model in
your explanation.
Answer: In the economic model of behavior, individuals substitute among goods based on
their relative prices. As gas prices go up, the price of speed on the highway goes up as well.
This causes individuals to demand less of it and to slow down. This will reduce the death
rate per mile driven.
Partial Credit: 2 pts for explaining that the price of going fast has increased and 2 pts for
drawing the implications of this.
b. (6 Pts.) For years, many advocacy groups have advocated strict enforcement of
highway speed limits in order to reduce the mortality rate per mile driven.
o

According to the economic model of behavior discussed in class, what

factor reduces the effectiveness of speed limits as a device to control
driving speeds?

Answer: In class we noted that individuals are clever and creative. They have devised
methods to evade the legal constraint against going fast by using radar detectors etc.
Partial Credit: 2 pts for clever and creative and 1 pt for the rest of the answer.
o

Using the lessons from part a) can you suggest alternative public policy
for reducing highway mortality?

Answer: An alternative policy that might work would be to raise the tax on gasoline. This
will cause people to slow down voluntarily and reduce mortality.
Partial Credit: 1 pt for valid suggestion and 2 pts for rest of the answer.

2. Agency Costs (10 pts.)

A factory manager wants to hire an employee to assemble products. Suppose that the
employee is capable of two effort levels (Low and High) resulting in the following
costs and value creation.
EFFORT LEVEL
Low
High

COST OF EMPLOYEE
EFFORT
$100
$200

PRODUCT VALUE
CREATED
$200
$500

In this case, Cost of Employee Effort is the dollar-equivalent cost to the employee of
exerting the effort levels indicated. Product Value Created is the amount that the
employees effort adds to the companys value.
a. (3 Pts.) Provide a concise definition of agency costs.
Answer: Agency costs arise where individuals do not bear the full costs (or reap the full
benefits) of their actions. Agency costs include Out-of-pocket costs to control incentive
problems and Residual loss because it does not pay to perfectly control incentive problems.
Partial credit: 2 pts for a reasonable definition and 1 pt for mentioning both out of pocket
costs and residual loss.
b. (4 Pts.) Assume that, due to difficulties in monitoring, only a low effort contract
can be enforced. What is the value of the resulting agency cost? Explain your
answer.
Answer: The agency cost is the loss in contract value from not being able to enforce the high
effort contract. Surplus from the low effort contract is $100 while it is $300 from the high
effort contract. So the agency cost is the difference, or $200.
Partial Credit: 4 pts for a correct numerical answer and nothing incorrect said in the
explanation. 2 pts potential partial credit for a good explanation but the wrong numerical
answer. 2 pts partial credit for the correct numerical answer but faulty reasoning behind the
answer.
c. (3 Pts.) Assume that if the plant manager invests $50 in plant supervision, the
high effort level can be enforced. Will the manager make this investment? What
is the dollar value of agency cost now? Will the employee oppose such an
investment? Explain.
Answer: Yes he will make the investment because the reduction in agency cost exceeds $50.
Agency cost is now $50, the out-of-pocket cost referred to in part (a). The employee will not
oppose this so long as he is paid fair compensation (or better) for his effort. The employer
can afford to compensate them for their added effort given the increase in value created.
Partial Credit: 1 pt for each part.

3. Decision Rights (C vs. D) (10 Pts.)

The modern automobile industry has changed greatly in the past 50 years. Years ago,
when General Motors controlled 50% of the American market, there were roughly 30 car
models around, half of which were made by General Motors. Production runs for
individual models were large for example, GM produced over 500,000 Chevy Impalas
per year.
Now, there are over 600 different models on the market, General Motors market share
has eroded to a fraction of its previous level and a successful single care model may sell
300,000 copies over its entire lifetime. A couple of years ago, an article in the Economist
reported, the trick is to make different models using the same underpinnings of parts
unseen by consumers. (Please ignore the effects of the recent financial crisis in
formulating your answers below).
a. (5 Pts.) In the old days the organizational structure of General Motors, known
for its different automobile divisions, was famous for both centralizing and
decentralizing key tasks. For example, marketing and new model introduction
decisions were centralized while key operating and engineering decisions were
decentralized to the divisions, whose managers were incented based upon the
profits of their division.
What was the rationale for centralizing marketing and decentralizing operational
decisions in the old GM model?
Answer: Because GM controlled such a large share of the market, any new model
introduction or marketing campaign risked cannibalizing its own market. Hence, new
model introductions and marketing needed to be coordinated centrally. Likewise, because
production runs were so large at each division, each division could achieve economies of
scale on their own. Hence production decisions could be decentralized.
Partial credit:
3 pts for marketing and 3 pts for production, maximum of 5.
b. (5 Pts.) In the new era described above, it makes sense to re-evaluate the
allocation of marketing and production decision rights. How do changes in
GMs environment change the way in which marketing and operating decision
rights should be allocated? Explain your reasoning.
In the new era, marketing and model introductions can be decentralized because GM does
not cannibalize its own market as much and because there is intense competition to market
in a timely fashion. On the other hand, production and engineering decisions need to be
centralized because divisions need to share parts and car platforms. These decisions need to
be coordinated across divisions.
Partial credit: Same as part a.

4. U Vs. M Form (10 Pts.)

An owner-manager operates several retail clothing stores in a single market.
The manager has a unique South American source for the companys inventory of
original alpaca clothing. Organizationally, the company uses a classic U form model
of organization. That is, the owner-manager closely supervises and coordinates all of
the major business functions, including purchasing, retail (store) management,
marketing and finance. Individual managers also oversee these functions so that, for
example, there is a head of marketing who reports directly to the owner. The owner
provides bonuses to her top managers based upon subjective evaluations of their work.
Because of its recent success, the company is planning to open locations (new stores) in a
neighboring state. The owner will not be able to monitor the new stores as effectively
as she monitors local operations.
a. (5 Pts.) A recent graduate of this class has suggested to the owner that she use an
M form management structure for the new stores. Each new store would be a
unique product or division with its own decision rights over inventory,
marketing and overall store operations. Each store would also have its own P
and L statement.
List and explain (2) advantages this would provide compared to the case where
the new store operations were simply folded into the existing U form.
Answer: The major advantage is that each store manager can be held accountable for their
own performance by using the stores P and L statement. This helps to address the problem
of monitoring cited above. Second, providing the store managers with decision rights over
issues such as marketing and inventory will allow them to make use of specific knowledge
about conditions in their own market.
Partial Credit: 3 Pts for the first advantage (with explanation) and 2 pts for the second.
b. (3 Pts.) List and explain one disadvantages or concern that the owner might have
with the M form strategy for new stores.
Answer: The company may lose the advantage of scale in areas such as marketing. Also, the
stores in the other state may compete with one another (not coordinate their efforts.)
Partial credit: 1 pt for a disadvantage and 2 pts for the explanation.
c. (2 Pts.) Why does it make sense to continue to centralize a function such as finance
(payroll, taxes, treasury etc.)?
Answer: There is nothing unique about these functions that justify each store coordinating
them. They are also scalable. Finally, there is considerable risk to the company as a whole if
they are performed incorrectly.
Partial Credit: 2 pts for a valid reason with explanation.

5. Incentives (10 Pts.)

Most experts predict that the current recession will extend well into the coming year
(2009) and perhaps into 2010. During this time period, sales for most companies are
expected to decline relative to their prior year values, although considerable uncertainty
remains about what will actually happen to sales in 2009 (greater uncertainty than in the
past).
Consider an electronics manufacturing company, with its own sales force. In this
company, 40% of compensation has historically been based upon commissions (a fixed
percentage of sales made is paid to the sales force). The sales people each sell in
different assigned territories. The territories, while different, have similar sales
environments and are equally impacted by the current recession, so that a salesperson
using the same effort and ability will book the same sales in any of the territories.
a. (5 Pts.) The head of sales has suggested that it would be unfair and unwise to
base 40% of salespersons pay upon commissions in 2009, when it is well know
that sales will decline in the coming year.
Using the theory of incentive pay and performance assessment, suggest and
explain a legitimate reason to support this position. Your reasons should
explain why it would be unwise for the firm to place the same weight on
commission-based pay in the coming year, using the theory of incentive pay
and performance assessment.
Answer: The environment is characterized by greater risk and uncertainty which theory
says should reduce the reliance on incentive pay.
Partial credit: 2 pts for reason and 3 pts for explanation.
b. (5 Pts.) Suggest a way to change or reform the commission-based system in the
coming year so that it may work more effectively in the context of the general
climate of economic uncertainty.
Answer: Relative performance assessment may work. Presumably the sales territories are
equally affected by the economy, so RPE can be used to remove the uncertainty of the
economic climate.
Partial Credit: 2 pts for answer and 3 pts for explanation.

6. (10 Pts.) Incentives and Performance Assessment Measures

In the early 1990s, a major manufacturing company lagged behind its competitors in
worker safety. Injuries were up to 10 times as high compared to other top firms. Most
injuries occurred due to a combination of plant conditions (unsafe arrangement of
machines and processes) or worker carelessness (e.g., putting hands inside of machines
during repair).
In response, this company undertook a major initiative to change company culture and
improve the injury rate. The major elements of the program were: 1) visible support by
executive and divisional leadership (strong message: we care about this); 2) education
programs that were attended by the leadership of each plant and; 3) a statement from
management that each plant manager would be held accountable for promoting a health
and injury free environment, although no explicit incentive plans were provided.
a. (4 Pts) If the company wanted to promote safety at the plant level, why didnt it
simply allocate safety goals to each plant manager together with explicit
incentives to achieve them? List and explain (2) difficulties that might exist with
using a scheme of this type. Be specific.
Answer: The difficulties with an incentive scheme would be: 1) setting reasonable standards
for improvement with no knowledge of what was attainable in the short run; 2) it may have
been difficult to find reasonable metrics of improvement that wouldnt be gamed (e.g.,
workers may be encouraged to not report injuries if the manager was rewarded for holding
the injury rate down); 3) the multi-task principal-agent problem may make if difficult to
configure effective incentives without sacrificing productivity; 4) top management may have
specific knowledge about how to improve safety that needs to be transmitted to the plants.
Partial Credit: 2 pts for each difficulty with setting standards (with explanation).
b. (3 Pts.) Given the difficulties that you cited in part (a), what role did visible signs
of managements support for safety play in achieving the safety goals?
Answer: Incentives to improve safety were implicit. Management has to engender trust that
it would reward good safety performance, even in the absence of explicit incentives. Visible
signs of support for safety improvement were a way to engender trust that desired behaviors
would be rewarded.
Partial Credit: 2 pts for mentioning implicit incentives, 1 pt for explanation.
c. (3 Pts.) Given the types of incentives in play, would you expect improvements in
safety to take longer than the case where (workable) explicit incentives were
provided? Explain.
It would take longer because managers would first have to develop a trust and understanding
that safety really matters. This would take time as reputation is only developed based on
tangible responses that occur in response to given actions (e.g., managers with good safety
records actually get promoted). Partial Credit: 1 pt for answer and 2 pts for explanation.