Managerial Economics and

Business Strategy 8th Edition

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Chapter 06
The Organization of the Firm

Multiple Choice Questions

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1. Often owners of firms who hire managers must install incentive or bonus plans to ensure that
the:

A. company is financially secure.

B. manager will work hard.
C. manager will maintain employee morale.
D. company will have positive economic profits.

2. Which of the following forms of payment is NOT an incentive plan?

A. Commission plans for salesmen

B. Flat salary for a plant manager
C. Bonuses for managers that increase as profits increase
D. None of the statements is correct.

3. Which of the following is NOT an incentive scheme to ensure that workers do a good job?

A. Paying waitresses low wages, but allowing them to collect tips

B. Profit-sharing plans in large companies
C. Commission pay schedules for salesmen
D. Straight hourly wages for dock workers

4. Which of the following is NOT a means of avoiding opportunism?

A. Contracts
B. Spot exchange
C. Vertical integration
D. Long-term contracts

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5. Long-term contracts become longer:

A. when specialized investment becomes more important.

B. when the exchange environment is more complex.
C. when spot markets work well.
D. when marginal costs are declining.

6. A relationship-specific exchange occurs when:

A. a partnership is dissolved.
B. specialized investments are important.
C. a partnership is initiated.
D. shareholders receive dividends.

7. When relationship-specific exchange occurs in complex contractual environments, the best

way to purchase inputs is through:

A. spot markets.
B. vertical integration.
C. short-term agency agreements.
D. long-term contracts.

8. A firm might choose to produce its own inputs if:

A. specialized investment is not important.

B. long-term contracts are costly to write.
C. the exchange environment is not complex.
D. spot markets for the input exist.

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9. An agent hired by the owner of productive resources to control the production process is:

A. a laborer.
B. a self-proprietor.
C. an assembly worker.
D. a firm manager.

10. Spot exchange can be inefficient in the presence of:

A. opportunism.
B. a complex contracting environment.
C. spot checks.
D. None of the statements is correct.

11. A negative side of long-term contracts is:

A. high transaction costs.

B. a loss of flexibility.
C. the continual need to renegotiate the contract.
D. None of the statements is correct.

12. Spot markets are an efficient way for the firm to purchase inputs if:

A. opportunism is not a problem.

B. suppliers engage in hold-up.
C. profit sharing is used to compensate managers.
D. the supplier needs specialized investment to produce the input.

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13. The disadvantage of vertical integration is that:

A. relationship-specific exchange may cause hold-up.

B. long-term contracts may be inflexible.
C. the principal-agent problem causes shirking.
D. firms no longer specialize in what they do best.

14. In the absence of worker incentives:

A. everyone always gives maximum effort.

B. there is a natural tendency for workers to not give their maximum effort.
C. managers have little or no control.
D. None of the statements is correct.

15. A person who monitors the production process and evaluates the productivity of workers is:

A. a manager.
B. an employee.
C. a shareholder.
D. a self-proprietor.

16. A drawback of separating ownership from control by creating a firm is:

A. the losses of specialization.

B. increased transaction costs.
C. the principal-agent problem.
D. synergies of team production.

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17. Shirking can take the form of:

A. long lunch hours.

B. sleeping at work.
C. leaving work early.
D. All of the statements associated with this question are correct.

18. Which of the following payment plans does NOT give an incentive to a manager to stop
shirking?

A. Flat salary with additional pay based on profits of the firm

B. Pay schedule based solely on profits earned by the firm
C. Flat salary regardless of firm profits
D. None of the statements is correct.

19. The most likely effect of reducing performance-based rewards for the CEOs of corporations
would be:

A. an increase in profits.
B. a drop in revenues.
C. a drop in profits.
D. an increase in the value of the corporation.

20. Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total

compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in
millions) = $400. How much will this CEO be compensated?

A. $812,431
B. $43,400
C. $559,432
D. $512,000

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21. Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total
compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in
millions) = $400. What percentage of the CEO's total earnings are tied to profits of the firm?

A. 8.2 percent
B. 10.9 percent
C. 7.8 percent
D. 5.1 percent

22. An incentive for managers to maximize profits is:

A. reputation.
B. performance bonuses.
C. takeovers.
D. All of the statements associated with this question are correct.

23. A manager who tries to enhance worker effort by tying workers' compensation to the
profitability of the firm is using:

A. spot checks.
B. revenue sharing.
C. profit sharing.
D. piece rates.

24. A payment plan that induces better worker effort by linking compensation to revenues of the
firm is known as:

A. revenue sharing.
B. profit sharing.
C. piece rate sharing.
D. spot checking.

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25. An example of a job that usually involves a revenue-sharing plan would be:

A. waiters and waitresses.

B. car salesman.
C. insurance agents.
D. All of the statements associated with this question are correct.

26. A negative side of a revenue-sharing plan is that it:

A. does not induce hard or better work.

B. can be costly if revenues are low.
C. gives no incentive for workers to minimize costs.
D. can be difficult to manage from an accounting standpoint.

27. Which of the following is NOT an example of a piece-rate compensation method?

A. Paying typists a fixed amount per page

B. Paying sewing machine operators a flat amount per shirt sewn
C. Paying a carpenter to install a new back porch
D. Paying an assembly line worker per bolt put into car bodies

28. A potential problem with piece-rate plans is that:

A. workers will produce a large quantity.

B. workers have no incentive to work hard.
C. it is difficult for managers to control.
D. workers may stress quantity instead of quality.

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29. When a manager enters the workplace from time to time to monitor workers, he is using:

A. a profit-sharing plan.
B. spot checks.
C. a revenue-sharing plan.
D. a piece-rate payment plan.

30. In order for spot checks to be effective, they must be:

A. random in nature.
B. performed at regular intervals.
C. partaken twice daily.
D. rarely if ever done.

31. Which type of compensation mechanism works by threats?

A. Piece rate
B. Spot check
C. Revenue sharing
D. Profit sharing

32. Which type of compensation method works by performance bonus?

A. Profit sharing
B. Revenue sharing
C. Piece rate
D. All of the statements associated with this question are correct.

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33. The most commonly used negative incentive used by firms is:

A. temporary layoffs.
B. dismissal.
C. unpaid suspensions.
D. verbal reprimands.

34. The LEAST risky payment plan from the viewpoint of the worker is:

A. piece rate.
B. profit sharing.
C. revenue sharing.
D. hourly wage.

35. To ensure quality, piece-rate plans must usually be accompanied by:

A. quality control mechanisms.

B. time clocks.
C. spot checks.
D. profit-sharing plans.

36. Transaction costs refer to:

A. fixed costs of capital.

B. variable costs of labor.
C. costs of exchange unrelated to production costs.
D. economies of scale.

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37. Spot checks:

A. measure presence only.

B. monitor the effort of workers precisely.
C. are the same as spot markets.
D. must be frequent enough to induce workers not to risk getting caught shirking.

38. Spot checks work because of:

A. the promise of a reward.

B. a promise of performance-based pay.
C. a potential penalty for shirking.
D. monitoring on a regular basis.

39. An increase in the likelihood of a dismissal:

A. raises productivity at an increasing rate.

B. raises productivity at a decreasing rate.
C. decreases productivity at a decreasing rate.
D. decreases productivity at an increasing rate.

40. High transaction costs:

A. occur when specialized investment is not important.

B. make spot exchange an efficient way to obtain inputs.
C. may be a result of buyer opportunism.
D. may be the result of downward-sloping demand.

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41. Long-term contracts are NOT efficient if:

A. a firm engages in relationship-specific exchange.

B. specialized investments are unimportant.
C. the contractual environment is simple.
D. managers shirk.

42. Which of the following occurs as firm size grows?

A. A decrease in the number of managers needed.

B. A decrease in transaction costs.
C. A loss of opportunity cost.
D. Administrative and bureaucratic costs rise at an increasing rate.

43. If a manager wishes to produce a large level of output, which compensation mechanism is
most effective?

A. Spot check
B. Piece rate
C. Revenue sharing
D. Profit sharing

44. Which of the following mergers is an example of vertical integration?

A. Bethlehem Steel purchases U.S. Steel.

B. IBM purchases a California computer chip company.
C. AT&T purchases MCI.
D. GM purchases Ford.

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45. If a firm manager has a base salary of $50,000 and also gets 2 percent of all profits, how much
will his/her income be if revenues are $8,000,000 and profits are $2,000,000?

A. $250,000
B. $210,000
C. $90,000
D. $150,000

46. If a firm manager has a base salary of $100,000 and also receives 5 percent of all profits, what
percentage of his/her final income will be from a profit-sharing plan when profit equals
$1,500,000?

A. 51 percent
B. 27 percent
C. 43 percent
D. 48 percent

47. The principal's goals are NOT in line with the goals of:

A. any other principal.

B. the agents.
C. the firms.
D. the consumers.

48. The agent is an individual:

A. who acts independently of the principal.

B. who can direct the principal to achieve goals.
C. hired by the principal to achieve goals.
D. hired by the principal to consult with him.

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
49. The principal-agent problem refers to the fact that the agent's goals:

A. do not always coincide with those of the principal.

B. coincide with those of the principal.
C. do not overlap with those of the principal.
D. overlap with those of the principal.

50. Principal-agent problems do NOT arise between:

A. stockholders and managers.

B. managers and workers.
C. stockholders and workers.
D. workers and consumers.

51. Solving the principal-agent problem ensures that the firm is operating:

A. on the production function.

B. above the production function.
C. below the production function.
D. above the isoquant curve.

52. Which of the following methods might be an efficient way of obtaining inputs when
specialized investments are not important?

A. Spot exchange
B. Vertical integration
C. Profit-sharing
D. Long-term contracts

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53. Specialized investments:

A. result in relationship-specific exchange.

B. make spot exchange efficient.
C. cause managers to shirk.
D. are equally valuable in any productive use.

54. Vertical integration:

A. occurs when a firm purchases its inputs in a market.

B. is attractive when relationship-specific exchange is unimportant.
C. occurs when a firm produces its own inputs.
D. is a spot exchange phenomenon.

55. If a manager is not the owner, the manager:

A. receives the full benefit of good decisions.

B. bears the full cost of bad decisions.
C. does not receive the full benefit nor the full cost of his or her decisions.
D. None of the statements is correct.

56. When the owner runs the business:

A. he does not bear the full cost of a bad decision.

B. there is not a principal-agent problem.
C. he does not receive the full benefit nor the full cost of any decision.
D. he has only limited liability for the actions of the business.

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57. A long-term contract:

A. occurs when a firm produces its own inputs.

B. is most likely in complex exchange environments.
C. exists when a firm is legally bound to purchase inputs from a particular supplier.
D. is shorter when specialized investments are important.

58. A spot exchange involves a market where goods are bought and sold at a:

A. contracted market price.

B. prevailing market price.
C. predetermined market price.
D. post-determined market price.

59. A firm chooses the institution to purchase inputs:

A. which minimizes the transactions costs of obtaining inputs.

B. in order to create more divisions.
C. which minimizes worker shirking.
D. to implement profit sharing.

60. Hold-up:

A. is a hazard associated with relationship-specific exchange.

B. mitigates worker shirking.
C. makes spot exchange efficient.
D. solves the principal-agent problem.

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
61. A firm manager is an agent hired by the:

A. owner to control the production process.

B. workers to control the production process.
C. workers to consult with the owner.
D. owner to oversee the workers.

62. The principal-agent problem happens because the owner cannot:

A. control the production process.

B. spend time at the physical plant site.
C. monitor the efforts of the manager.
D. evaluate the efforts of the manager.

63. Spot exchange typically involves:

A. no transaction costs.
B. some transaction costs.
C. extremely high transaction costs.
D. long-term contracts.

64. Long-term contracts:

A. increase transaction costs and increase opportunism.

B. increase transaction costs.
C. can reduce opportunistic behavior.
D. reduce transaction costs and increase flexibility.

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65. The problem with spot exchange in the presence of specific assets is that both parties:

A. have incentives to behave as principals.

B. have incentives to behave opportunistically.
C. take the risk of price fluctuations.
D. do not take advantage of the economies of scope.

66. Relationship-specific investments include:

A. site specificity.
B. dedicated assets.
C. human capital.
D. All of the statements associated with this question are correct.

67. One way of alleviating opportunism is:

A. spot exchange.
B. dedicated assets.
C. vertical integration.
D. contracts in complex contracting environments.

68. The specificity of the asset (or investment) leads to the possibility of:

A. collusion.
B. prisoner's dilemma.
C. opportunism.
D. None of the statements is correct.

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69. Which of the following institutions may result in hold-up?

A. Vertical integration
B. Piece rates
C. Long-term contracts
D. Spot markets

70. Relationship-specific exchange:

A. is a consequence of profit sharing.

B. makes firms use spot markets.
C. occurs because of specialized investments.
D. reduces worker shirking.

71. Long-term contracts are LESS likely when:

A. specialized investments are important.

B. hold-up is likely.
C. the exchange environment is complex.
D. workers are paid based on piece rates.

72. Under a profit-sharing compensation scheme, the manager will:

A. shirk all day.

B. not shirk all day.
C. optimize his choice between income and leisure.
D. do the same thing as under a fixed salary scheme.

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
73. By making managerial compensation depend on the performance of the firm's profits, the firm
owner's profits:

A. rise.
B. fall.
C. remain constant.
D. initially fall, then rise.

74. Given that the income of franchise restaurant managers is directly tied to profits and the
income of the manager of the company-owned restaurant is paid a flat fee, we might expect
profits to be:

A. higher in company-owned restaurants.

B. lower in company-owned restaurants.
C. equal in both types of restaurants.
D. None of the statements are correct.

75. Franchising mitigates:

A. opportunism.
B. relationship-specific investment.
C. the hold-up problem.
D. the principal-agent problem.

76. It would be undesirable to reduce the executive's compensation if her earnings are due largely
to:

A. a flat fee.
B. performance.
C. the owner's demand.
D. the employee's demand.

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77. If we reduce performance-based rewards to CEOs, the profits of firms will:

A. rise.
B. fall.
C. remain constant.
D. None of the answers are correct.

78. Which of the following is an outside incentive that forces managers to put forth maximal
effort?

A. Incentive contracts
B. Performance bonuses
C. Flat fees
D. Reputation

79. The cost to a manager of doing a poor job running the firm is:

A. a decrease in his fixed salary.

B. a decrease in the profit of the firm.
C. a decrease in the sales of the firm.
D. an increase in the likelihood of being replaced.

80. Which of the following is NOT a solution to the manager-worker principal-agent problem?

A. Sales sharing
B. Piece rates
C. Fixed hourly wages
D. Spot checks

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81. A profit-sharing pay scheme:

A. increases both productivity and profits.

B. decreases productivity but increases profits.
C. increases productivity but decreases profits.
D. decreases both productivity and profits.

82. One problem with revenue-based incentive schemes is they do NOT provide an incentive to:

A. maximize profit.
B. maximize sales.
C. minimize costs.
D. maximize productivity.

83. A potential problem with paying workers based on a piece rate is that:

A. effort cannot be expended engaging in quality control.

B. effort should not be expended engaging in quality control.
C. workers will attempt to produce quality at the expense of quantity.
D. workers will attempt to produce quantity at the expense of quality.

84. Which of the following is NOT a benefit associated with producing inputs within a firm?

A. reduction in transaction costs.

B. gains of specializing.
C. reductions in opportunism.
D. mitigation of hold-up problem.

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85. In order for spot checks to work:

A. employees must be monitored continually.

B. the time of the checks must not be predictable.
C. Both employees must be monitored continually and the time of the checks must not be
predictable are correct.
D. None of the answers are correct.

86. Which of the following involves the most risk from the point of view of the employee?

A. Piece rate
B. Profit sharing
C. Hourly wage
D. Annual salary

87. Long-term contracts are generally preferable to:

A. spot markets.
B. short-term contracts.
C. vertical integration.
D. None of the statements is correct.

88. Which of the following is the primary disadvantage of producing inputs within a firm?

A. Increases in transaction costs

B. Loss of specialization
C. Reductions in opportunism
D. Mitigation of hold-up problems

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89. Which of the following involves the LEAST risk from the point of view of the employee?

A. Piece rate
B. Profit sharing
C. Revenue sharing
D. Annual salary

90. Spot markets are generally preferable to:

A. long-term contracts.
B. short-term contracts.
C. vertical integration.
D. None of the answers are correct.

91. Which of the following forms of payment is NOT an incentive plan?

A. Commission plans for salespeople

B. Paying waitresses low wages, but allowing them to collect tips
C. Bonuses for managers that increase with profits
D. Straight hourly wages for construction workers

92. A positive side of long-term contracts is:

A. low transaction costs.

B. a loss of flexibility.
C. the continual need to renegotiate the contract.
D. None of the answers are correct.

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93. Spot markets are an INEFFICIENT way for the firm to purchase inputs if:

A. opportunism is a problem.
B. suppliers engage in hold-up.
C. profit sharing is used to compensate managers.
D. opportunism is a problem and suppliers engage in hold-up.

94. The activity known as shirking is LEAST likely to occur when:

A. workers are not monitored.

B. the earnings of a worker are closely tied to the worker's output.
C. all workers are paid the same wage rate.
D. firm ownership is separated from the managerial control.

95. Suppose compensation is given by W = 450,000 + 220 π + 15S, where W = total

compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in
millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 6.0 percent
B. 7.9 percent
C. 12.6 percent
D. 43.4 percent

96. Revenue sharing tries to induce worker effort by linking:

A. worker compensation to profits.

B. worker compensation to revenues.
C. worker output to profits.
D. worker output to revenues.

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97. A potential problem with piece-rate plans is that:

A. workers will have a tendency to under-produce the good.

B. workers have no incentive to work hard.
C. workers may put little emphasis on the quality of the good.
D. it is difficult for managers to enforce.

98. Which type of compensation method does NOT involve a performance bonus?

A. Profit sharing
B. Revenue sharing
C. Piece rate
D. None of the answers are correct.

99. Which of the following is NOT a transaction cost associated with using inputs?

A. Time spent negotiating labor contracts with union workers

B. Opportunity costs of negotiating the price of renting machines
C. Wages paid to labor
D. Costs of searching for a new supplier of machines

100.As firms increase in size, they tend to experience a:

A. decrease in the need for managers.

B. decrease in transaction costs.
C. loss of opportunity cost.
D. None of the answers are correct.

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101.Suppose a firm manager has a base salary of $75,000 and earns 1.5 percent of all profits.
Determine the manager's income, if revenues are $10,000,000 and profits are $5,000,000.

A. $75,000
B. $150,000
C. $225,000
D. $300,000

102.Given that the income for a franchise restaurant manager is directly tied to profits, while the
income for the manager of a company-owned restaurant is paid a flat fee, we might expect
profits to be:

A. lower in franchise restaurants.

B. higher in franchise restaurants.
C. equal in both types of restaurants.
D. Profit comparisons cannot be made based on the given information.

103.Generally, revenue-based incentive schemes:

A. reduce incentives to produce low-quality products.

B. increase incentives to minimize costs.
C. reduce worker productivity.
D. reduce incentives to produce low-quality products and increase incentives to minimize
costs.

104.Which of the following is an outside incentive that forces managers to put forth maximal
effort?

A. Revenue-sharing contracts
B. Performance bonuses
C. Threat of takeovers
D. Flat fees

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105.Point A in the figure below is:

A. efficient since it produces 20 units of output at the lowest possible cost.

B. efficient since it produces 10 units of output at the lowest possible cost.
C. inefficient since it produces 20 units of output at a cost greater than the minimum cost.
D. inefficient since it produces 10 units of output at a cost greater than the minimum cost.

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106.Point B in the figure below is:

A. efficient since it produces 20 units of output at the lowest possible cost.

B. efficient since it produces 10 units of output at the lowest possible cost.
C. inefficient since it produces 20 units of output at a cost greater than the minimum cost.
D. inefficient since it produces 10 units of output at a cost greater than the minimum cost.

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107.Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and
the marginal cost of that contract is $50. Based on this information, the optimal contract
length should:

A. be increased.
B. be decreased by half.
C. be decreased by two-thirds.
D. be held constant at the contract length where MB = 100 and MC = 50.

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108.Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and
the marginal cost of that contract is $150. Based on this information, the optimal contract
length should be:

A. increased by half.
B. increased by two-thirds.
C. decreased.
D. held constant at the contract length where MB = 100 and MC = 150.

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109.Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100 and
the marginal cost of that contract is $100. Based on this information, the optimal contract
length should be:

A. increased by half.
B. increased by two-thirds.
C. decreased.
D. held constant at the contract length where MB = 100 and MC = 100.

110.Suppose a new contracting environment that requires greater specialized investments is

considered. This new contract will result in:

A. an increase in the marginal benefit and a longer optimal contract.

B. an increase in the marginal benefit and a shorter optimal contract.
C. a decrease in the marginal benefit and a longer optimal contract.
D. a decrease in the marginal benefit and a shorter optimal contract.

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111.Suppose a new contracting environment that requires less specialized investments is
considered. This new contract will result in:

A. an increase in the marginal benefit and a longer optimal contract.

B. an increase in the marginal benefit and a shorter optimal contract.
C. a decrease in the marginal benefit and a longer optimal contract.
D. a decrease in the marginal benefit and a shorter optimal contract.

112.Suppose a new contracting environment that requires clearing fewer legal hurdles is
considered. This new contract will result in:

A. an increase in the marginal cost and a longer optimal contract.

B. an increase in the marginal cost and a shorter optimal contract.
C. a decrease in the marginal cost and a longer optimal contract.
D. a decrease in the marginal cost and a shorter optimal contract.

113.Suppose a new contracting environment with an economic environment that looks more
uncertain is considered. This new contract will result in:

A. an increase in the marginal cost and a longer optimal contract.

B. an increase in the marginal cost and a shorter optimal contract.
C. a decrease in the marginal cost and a longer optimal contract.
D. a decrease in the marginal cost and a shorter optimal contract.

114.The presence of substantial specialized investment relative to contracting costs suggests that
the optimal input procurement method is:

A. spot exchange.
B. vertical integration.
C. contract.
D. vertical integration or contract.

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115.The presence of minimal specialized investments relative to contracting costs suggests that
the optimal input procurement method is:

A. spot exchange.
B. vertical integration.
C. contract.
D. vertical integration or contract.

116.EFI Conveyor Systems recently visited a local AC motor distributor. This transaction most
likely involves:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

117.Sydney Roofers Incorporated recently purchased 100 pounds of standard roofing nails from
Lowes, a nationwide hardware and building supplies store. This transaction most likely
involves:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

118.General Motors purchased Fischer Auto Body to produce bodies to place on a chassis. This
transaction is best described as:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

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119.Which of the following is NOT an implication of specialized investments that lead to increased
transaction costs?

A. Costly bargaining
B. Opportunism and the hold-up problem
C. Underinvestment in specialized investments
D. Incentive contracts

120.Piece rates are typically a solution to the:

A. manager-worker, principal-agent problem.

B. manager-owner, principal-agent problem.
C. owner-worker, principal-agent problem.
D. None of the statements is correct.

121.Time clocks are typically a solution to the:

A. manager-consumer, principal-agent problem.

B. manager-owner, principal-agent problem.
C. consumer-worker, principal-agent problem.
D. None of the statements is correct.

122.Spot checks are typically a solution to the:

A. manager-consumer, principal-agent problem.

B. manager-worker, principal-agent problem.
C. consumer-worker, principal-agent problem.
D. None of the statements is correct.

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123.The threat of a corporate takeover is an _________ incentive that helps to mitigate the
_________ principal-agent problem.

A. internal; manager-worker
B. internal; manager-consumer
C. external; owner-manager
D. external; owner-consumer

124.Managerial reputation is an _____ incentive that helps to mitigate the _______ principal-agent
problem.

A. internal; manager-worker
B. internal; manager-consumer
C. external; owner-manager
D. external; owner-consumer

125.A decrease in the marginal benefit arising from a specialized investment will cause the
optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

126.An increase in the marginal cost arising from a more complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

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127.A decrease in the marginal cost arising from a less complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

128.Which of the following is NOT a solution to the manager-worker principal-agent problem?

A. Revenue sharing
B. Profit sharing
C. Time clocks and spot checks
D. The threat of a takeover

129.Which of the following is NOT a type of specialized investment?

A. Site specificity
B. Physical-asset specificity
C. Human capital
D. All of the statements associated with this question are types of specialized investments.

130.Long-term contracts become shorter:

A. when specialized investment becomes less important.

B. when the exchange environment is less complex.
C. when spot markets work poorly.
D. when marginal costs are increasing.

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131.An increase in the marginal cost arising from a more complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

132.An increase in the marginal benefit arising from a specialized investment will cause the
optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

133.Suppose a firm manager has a base salary of $175,000 and earns 0.5 percent of all profits.
Determine the manager's income if revenues are $10,000,000 and profits are $5,000,000.

A. $150,000
B. $200,000
C. $225,000
D. $300,000

134.Suppose a firm manager has a base salary of $50,000 and earns 2.5 percent of all sales.
Determine the manager's income if revenues are $20,000,000 and profits are $5,000,000.

A. $50,000
B. $175,000
C. $550,000
D. $700,000

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135.Suppose a firm manager has a base salary of $85,000 and earns 0.5 percent of all sales.
Determine the manager's income if revenues are $2,000,000 and profits are $500,000.

A. $50,000
B. $87,500
C. $95,000
D. $170,000

136.Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total

compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in
millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 1.5 percent
B. 7.9 percent
C. 10.6 percent
D. 43.4 percent

137.Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total

compensation of the CEO, π = company profits (in millions) = $400, and S = sales (in
millions) = $700. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 2.0 percent
B. 13.5 percent
C. 19.6 percent
D. 31.4 percent

138.Suppose compensation is given by W = 100,000 + 157 π + 12S, where W = total

compensation of the CEO, π = company profits (in millions) = $340, and S = sales (in
millions) = $700. What percentage of the CEO's total earnings is tied to sales of the firm?

A. 5.2 percent
B. 13.5 percent
C. 19.6 percent
D. 33.0 percent

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139.By instituting performance-based rewards to CEOs the profits of firms will:

A. rise.
B. fall.
C. remain constant.
D. None of the statements is correct.

Essay Questions

140.Determine whether the following transactions involve spot exchange, contracts, or vertical
integration.

a. A major oil company refines gasoline from crude oil produced by oil wells that it owns.
b. Transcontinental, an interstate natural-gas pipeline, has a legal obligation to purchase a
specified amount of gas per week from a well owned by Fred Smith in Enid, Oklahoma.
c. A cabinetmaker purchases a dozen wood screws from the local hardware store.
d. An electric utility purchases coal from an underground mine.

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141.In general, automobile manufacturers produce their own engines but purchase tires from
independent suppliers. Why?

142.Which of the following transactions are likely to result in relationship-specific exchange?

a. Purchasing gasoline for the company car

b. Hiring an employee to operate a machine that only your company uses
c. Buying napkins for the company snack bar
d. Purchasing coal for the factory furnace
e. Buying electricity

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143.Explain how each of the following affects the optimal method of acquiring an input.

a. A complex contracting environment

b. A specialized investment
c. Opportunism
d. Bargaining costs
e. The costs of bureaucracy
f. Gains from specialization

144.Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound hamburgers in a given

week. To meet that demand, Jiffyburger needs 2,000 pounds of ground beef delivered to its
premises every Monday morning by 8:00 A.M. sharp. If you were the manager of a Jiffyburger
franchise, how would you acquire the ground beef? Explain.

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145.Explain why people in the following occupations are compensated as they are.

a. Insurance agents
b. Football players
c. Authors
d. CEOs of major corporations
e. Food servers

146.A manager derives satisfaction from income and leisure on the job (shirking).

a. If the manager is paid a fixed salary of $100,000, how much leisure will she consume on the
job during an eight-hour day? Explain.
b. When the manager is given a salary of $100,000 plus 10 percent of the firm's profits, she
chooses to spend six hours managing and two hours consuming leisure. Salary and bonus
total $120,000. Does the manager necessarily prefer this situation to the situation in part (a)?

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147.Is it necessarily in the best interests of shareholders for management to ensure that there is
absolutely no shirking in the workplace? Explain.

148.Discuss the benefits and costs of the following methods of monitoring worker performance:

a. Hidden video cameras in the workplace.

b. Time clocks.
c. Paying workers based on the output they produce.

149.According to Industry Week, a shoe manufacturer recently had a production run that resulted
in 100,000 pairs of defective shoes. Workers on the production line knew the shoes were
defective as they were being produced, but did nothing to fix the problem. Do you think a
profit-sharing plan for workers would mitigate future problems? Explain.

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150.College Retirement Equities Fund (CREF) is a pension fund that has billions of dollars
invested in the stock market. Fund participants recently voted on a proposal that would have
placed strict limits on the amount of compensation paid to CREF executives. Why do you think
75 percent of the participants voted against the proposal?

151.Suppose a principal knew with certainty the level of profits that would result if an agent put
forth maximum effort.

a. Would there be a principal-agent problem?

b. Devise two incentive contracts that would induce the manager to put forth maximum effort
in this instance.

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152.Dallas-based Southwest Airlines recently announced a 10-year contract that gives pilots a
greater opportunity to share in the profits of the airline. According to the terms of the
contract, the pilots will receive options to buy 14 million shares of the firm's stock over the
next 10 years. What impact do you think this new contract will have on Southwest Airlines?

153.Art-R-Us makes hand-painted art reproductions. The owner-manager wishes to hire another
artist, and is considering paying a fixed wage plus either (1) a share of the profits from each
painting sold or (2) a fixed payment for each piece produced. Which plan would you choose if
you were the owner? Explain.

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154.In a 1998 press release, Boeing Commercial Airplane Group (BCAG) announced that it was
signing a 10-year contract with distributor Thyssen Inc., a distributor of raw aluminum, valued
at approximately $300 million. The contract reflected Boeing's effort to reduce costs and
production bottlenecks resulting from supply shortages. The contract specified prices and
guaranteed quantities of raw aluminum to be delivered to BCAG's suppliers. If you were the
production manager at BCAG, how would you justify the long-term nature of the contact with
Thyssen Inc.?

155.As a manager of the WeDoWell Corporation, you have negotiated with several vendors and
are on the verge of signing an eight-year contract with Bolts Enterprises. Under the contract,
they would ship to you 2,000 titanium bolts per month at a price of $1,000 per bolt. Your
assistant has just brought you an article from a trade publication that indicates another
company has developed a new technology that reduces the cost of producing the titanium
bolts. How would this information affect the optimal length of your contract with Bolts
Enterprises? Explain.

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156.At the recent shareholders' meeting, the CEO of a small bank proposed a plan to offer each of
its employees 250 incentive options for Class A common stock. The key provisions of the plan
are that employees must exercise the options between January 2014 and December 2019, and
if an employee terminates his or her employment with the bank (or is terminated), the options
are no longer exercisable. One shareholder feverishly objected to the plan, claiming that such
a move would dilute the value of the outstanding shares. As CEO, how would you defend the
stock option plan to the shareholders?

157.You are the manager of Door-to-Door Vacuum Cleaners, Inc. Each salesperson is paid a base
salary plus a percentage of the revenues she or he generates. In addition, each salesperson
drives his or her car to and from each sales call and is reimbursed $0.40 per mile driven. On
average, each salesperson drives about 150 miles per day and 240 days per year. As manager
of Door-to-Door, how might you restructure the compensation of your sales force to enhance
your profits? Are there any potential disadvantages of your plan? Explain.

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 Chapter 06 The Organization of the Firm Answer Key

Multiple Choice Questions

1. Often owners of firms who hire managers must install incentive or bonus plans to ensure
that the:

A. company is financially secure.

B. manager will work hard.
C. manager will maintain employee morale.
D. company will have positive economic profits.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

2. Which of the following forms of payment is NOT an incentive plan?

A. Commission plans for salesmen

B. Flat salary for a plant manager
C. Bonuses for managers that increase as profits increase
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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3. Which of the following is NOT an incentive scheme to ensure that workers do a good job?

A. Paying waitresses low wages, but allowing them to collect tips

B. Profit-sharing plans in large companies
C. Commission pay schedules for salesmen
D. Straight hourly wages for dock workers

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: The Manager-Worker Principal-Agent Problem

4. Which of the following is NOT a means of avoiding opportunism?

A. Contracts
B. Spot exchange
C. Vertical integration
D. Long-term contracts

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

5. Long-term contracts become longer:

A. when specialized investment becomes more important.

B. when the exchange environment is more complex.
C. when spot markets work well.
D. when marginal costs are declining.

AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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6. A relationship-specific exchange occurs when:

A. a partnership is dissolved.
B. specialized investments are important.
C. a partnership is initiated.
D. shareholders receive dividends.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

7. When relationship-specific exchange occurs in complex contractual environments, the best

way to purchase inputs is through:

A. spot markets.
B. vertical integration.
C. short-term agency agreements.
D. long-term contracts.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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8. A firm might choose to produce its own inputs if:

A. specialized investment is not important.

B. long-term contracts are costly to write.
C. the exchange environment is not complex.
D. spot markets for the input exist.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

9. An agent hired by the owner of productive resources to control the production process is:

A. a laborer.
B. a self-proprietor.
C. an assembly worker.
D. a firm manager.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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10. Spot exchange can be inefficient in the presence of:

A. opportunism.
B. a complex contracting environment.
C. spot checks.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

11. A negative side of long-term contracts is:

A. high transaction costs.

B. a loss of flexibility.
C. the continual need to renegotiate the contract.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

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12. Spot markets are an efficient way for the firm to purchase inputs if:

A. opportunism is not a problem.

B. suppliers engage in hold-up.
C. profit sharing is used to compensate managers.
D. the supplier needs specialized investment to produce the input.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

13. The disadvantage of vertical integration is that:

A. relationship-specific exchange may cause hold-up.

B. long-term contracts may be inflexible.
C. the principal-agent problem causes shirking.
D. firms no longer specialize in what they do best.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

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14. In the absence of worker incentives:

A. everyone always gives maximum effort.

B. there is a natural tendency for workers to not give their maximum effort.
C. managers have little or no control.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: The Manager-Worker Principal-Agent Problem

15. A person who monitors the production process and evaluates the productivity of workers
is:

A. a manager.
B. an employee.
C. a shareholder.
D. a self-proprietor.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: The Manager-Worker Principal-Agent Problem

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16. A drawback of separating ownership from control by creating a firm is:

A. the losses of specialization.

B. increased transaction costs.
C. the principal-agent problem.
D. synergies of team production.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

17. Shirking can take the form of:

A. long lunch hours.

B. sleeping at work.
C. leaving work early.
D. All of the statements associated with this question are correct.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: The Manager-Worker Principal-Agent Problem

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18. Which of the following payment plans does NOT give an incentive to a manager to stop
shirking?

A. Flat salary with additional pay based on profits of the firm

B. Pay schedule based solely on profits earned by the firm
C. Flat salary regardless of firm profits
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

19. The most likely effect of reducing performance-based rewards for the CEOs of corporations
would be:

A. an increase in profits.
B. a drop in revenues.
C. a drop in profits.
D. an increase in the value of the corporation.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

6-57
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
20. Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total
compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in
millions) = $400. How much will this CEO be compensated?

A. $812,431
B. $43,400
C. $559,432
D. $512,000

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

21. Suppose compensation is given by W = 512,000 + 217π + 10.08S, where W = total

compensation of the CEO, π = company profits (in millions) = $200, and S = sales (in
millions) = $400. What percentage of the CEO's total earnings are tied to profits of the
firm?

A. 8.2 percent
B. 10.9 percent
C. 7.8 percent
D. 5.1 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-58
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
22. An incentive for managers to maximize profits is:

A. reputation.
B. performance bonuses.
C. takeovers.
D. All of the statements associated with this question are correct.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

23. A manager who tries to enhance worker effort by tying workers' compensation to the
profitability of the firm is using:

A. spot checks.
B. revenue sharing.
C. profit sharing.
D. piece rates.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-59
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
24. A payment plan that induces better worker effort by linking compensation to revenues of
the firm is known as:

A. revenue sharing.
B. profit sharing.
C. piece rate sharing.
D. spot checking.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

25. An example of a job that usually involves a revenue-sharing plan would be:

A. waiters and waitresses.

B. car salesman.
C. insurance agents.
D. All of the statements associated with this question are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-60
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
26. A negative side of a revenue-sharing plan is that it:

A. does not induce hard or better work.

B. can be costly if revenues are low.
C. gives no incentive for workers to minimize costs.
D. can be difficult to manage from an accounting standpoint.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

27. Which of the following is NOT an example of a piece-rate compensation method?

A. Paying typists a fixed amount per page

B. Paying sewing machine operators a flat amount per shirt sewn
C. Paying a carpenter to install a new back porch
D. Paying an assembly line worker per bolt put into car bodies

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

28. A potential problem with piece-rate plans is that:

A. workers will produce a large quantity.

B. workers have no incentive to work hard.
C. it is difficult for managers to control.
D. workers may stress quantity instead of quality.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-61
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
29. When a manager enters the workplace from time to time to monitor workers, he is using:

A. a profit-sharing plan.
B. spot checks.
C. a revenue-sharing plan.
D. a piece-rate payment plan.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

30. In order for spot checks to be effective, they must be:

A. random in nature.
B. performed at regular intervals.
C. partaken twice daily.
D. rarely if ever done.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

31. Which type of compensation mechanism works by threats?

A. Piece rate
B. Spot check
C. Revenue sharing
D. Profit sharing

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-62
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
32. Which type of compensation method works by performance bonus?

A. Profit sharing
B. Revenue sharing
C. Piece rate
D. All of the statements associated with this question are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

33. The most commonly used negative incentive used by firms is:

A. temporary layoffs.
B. dismissal.
C. unpaid suspensions.
D. verbal reprimands.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

34. The LEAST risky payment plan from the viewpoint of the worker is:

A. piece rate.
B. profit sharing.
C. revenue sharing.
D. hourly wage.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-63
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
35. To ensure quality, piece-rate plans must usually be accompanied by:

A. quality control mechanisms.

B. time clocks.
C. spot checks.
D. profit-sharing plans.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

36. Transaction costs refer to:

A. fixed costs of capital.

B. variable costs of labor.
C. costs of exchange unrelated to production costs.
D. economies of scale.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
37. Spot checks:

A. measure presence only.

B. monitor the effort of workers precisely.
C. are the same as spot markets.
D. must be frequent enough to induce workers not to risk getting caught shirking.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

38. Spot checks work because of:

A. the promise of a reward.

B. a promise of performance-based pay.
C. a potential penalty for shirking.
D. monitoring on a regular basis.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

39. An increase in the likelihood of a dismissal:

A. raises productivity at an increasing rate.

B. raises productivity at a decreasing rate.
C. decreases productivity at a decreasing rate.
D. decreases productivity at an increasing rate.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-65
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
40. High transaction costs:

A. occur when specialized investment is not important.

B. make spot exchange an efficient way to obtain inputs.
C. may be a result of buyer opportunism.
D. may be the result of downward-sloping demand.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

41. Long-term contracts are NOT efficient if:

A. a firm engages in relationship-specific exchange.

B. specialized investments are unimportant.
C. the contractual environment is simple.
D. managers shirk.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

6-66
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
42. Which of the following occurs as firm size grows?

A. A decrease in the number of managers needed.

B. A decrease in transaction costs.
C. A loss of opportunity cost.
D. Administrative and bureaucratic costs rise at an increasing rate.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

43. If a manager wishes to produce a large level of output, which compensation mechanism is
most effective?

A. Spot check
B. Piece rate
C. Revenue sharing
D. Profit sharing

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-67
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
44. Which of the following mergers is an example of vertical integration?

A. Bethlehem Steel purchases U.S. Steel.

B. IBM purchases a California computer chip company.
C. AT&T purchases MCI.
D. GM purchases Ford.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

45. If a firm manager has a base salary of $50,000 and also gets 2 percent of all profits, how
much will his/her income be if revenues are $8,000,000 and profits are $2,000,000?

A. $250,000
B. $210,000
C. $90,000
D. $150,000

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-68
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
46. If a firm manager has a base salary of $100,000 and also receives 5 percent of all profits,
what percentage of his/her final income will be from a profit-sharing plan when profit
equals $1,500,000?

A. 51 percent
B. 27 percent
C. 43 percent
D. 48 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

47. The principal's goals are NOT in line with the goals of:

A. any other principal.

B. the agents.
C. the firms.
D. the consumers.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-69
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
48. The agent is an individual:

A. who acts independently of the principal.

B. who can direct the principal to achieve goals.
C. hired by the principal to achieve goals.
D. hired by the principal to consult with him.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

49. The principal-agent problem refers to the fact that the agent's goals:

A. do not always coincide with those of the principal.

B. coincide with those of the principal.
C. do not overlap with those of the principal.
D. overlap with those of the principal.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

50. Principal-agent problems do NOT arise between:

A. stockholders and managers.

B. managers and workers.
C. stockholders and workers.
D. workers and consumers.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
51. Solving the principal-agent problem ensures that the firm is operating:

A. on the production function.

B. above the production function.
C. below the production function.
D. above the isoquant curve.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

52. Which of the following methods might be an efficient way of obtaining inputs when
specialized investments are not important?

A. Spot exchange
B. Vertical integration
C. Profit-sharing
D. Long-term contracts

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

6-71
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
53. Specialized investments:

A. result in relationship-specific exchange.

B. make spot exchange efficient.
C. cause managers to shirk.
D. are equally valuable in any productive use.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

54. Vertical integration:

A. occurs when a firm purchases its inputs in a market.

B. is attractive when relationship-specific exchange is unimportant.
C. occurs when a firm produces its own inputs.
D. is a spot exchange phenomenon.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

6-72
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
55. If a manager is not the owner, the manager:

A. receives the full benefit of good decisions.

B. bears the full cost of bad decisions.
C. does not receive the full benefit nor the full cost of his or her decisions.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

56. When the owner runs the business:

A. he does not bear the full cost of a bad decision.

B. there is not a principal-agent problem.
C. he does not receive the full benefit nor the full cost of any decision.
D. he has only limited liability for the actions of the business.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-73
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
57. A long-term contract:

A. occurs when a firm produces its own inputs.

B. is most likely in complex exchange environments.
C. exists when a firm is legally bound to purchase inputs from a particular supplier.
D. is shorter when specialized investments are important.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 3 Hard
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

58. A spot exchange involves a market where goods are bought and sold at a:

A. contracted market price.

B. prevailing market price.
C. predetermined market price.
D. post-determined market price.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

6-74
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
59. A firm chooses the institution to purchase inputs:

A. which minimizes the transactions costs of obtaining inputs.

B. in order to create more divisions.
C. which minimizes worker shirking.
D. to implement profit sharing.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

60. Hold-up:

A. is a hazard associated with relationship-specific exchange.

B. mitigates worker shirking.
C. makes spot exchange efficient.
D. solves the principal-agent problem.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

6-75
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
61. A firm manager is an agent hired by the:

A. owner to control the production process.

B. workers to control the production process.
C. workers to consult with the owner.
D. owner to oversee the workers.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

62. The principal-agent problem happens because the owner cannot:

A. control the production process.

B. spend time at the physical plant site.
C. monitor the efforts of the manager.
D. evaluate the efforts of the manager.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-76
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
63. Spot exchange typically involves:

A. no transaction costs.
B. some transaction costs.
C. extremely high transaction costs.
D. long-term contracts.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

64. Long-term contracts:

A. increase transaction costs and increase opportunism.

B. increase transaction costs.
C. can reduce opportunistic behavior.
D. reduce transaction costs and increase flexibility.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

6-77
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
65. The problem with spot exchange in the presence of specific assets is that both parties:

A. have incentives to behave as principals.

B. have incentives to behave opportunistically.
C. take the risk of price fluctuations.
D. do not take advantage of the economies of scope.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

66. Relationship-specific investments include:

A. site specificity.
B. dedicated assets.
C. human capital.
D. All of the statements associated with this question are correct.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

6-78
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
67. One way of alleviating opportunism is:

A. spot exchange.
B. dedicated assets.
C. vertical integration.
D. contracts in complex contracting environments.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

68. The specificity of the asset (or investment) leads to the possibility of:

A. collusion.
B. prisoner's dilemma.
C. opportunism.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
69. Which of the following institutions may result in hold-up?

A. Vertical integration
B. Piece rates
C. Long-term contracts
D. Spot markets

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

70. Relationship-specific exchange:

A. is a consequence of profit sharing.

B. makes firms use spot markets.
C. occurs because of specialized investments.
D. reduces worker shirking.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
71. Long-term contracts are LESS likely when:

A. specialized investments are important.

B. hold-up is likely.
C. the exchange environment is complex.
D. workers are paid based on piece rates.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

72. Under a profit-sharing compensation scheme, the manager will:

A. shirk all day.

B. not shirk all day.
C. optimize his choice between income and leisure.
D. do the same thing as under a fixed salary scheme.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
73. By making managerial compensation depend on the performance of the firm's profits, the
firm owner's profits:

A. rise.
B. fall.
C. remain constant.
D. initially fall, then rise.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

74. Given that the income of franchise restaurant managers is directly tied to profits and the
income of the manager of the company-owned restaurant is paid a flat fee, we might
expect profits to be:

A. higher in company-owned restaurants.

B. lower in company-owned restaurants.
C. equal in both types of restaurants.
D. None of the statements are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-82
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
75. Franchising mitigates:

A. opportunism.
B. relationship-specific investment.
C. the hold-up problem.
D. the principal-agent problem.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

76. It would be undesirable to reduce the executive's compensation if her earnings are due
largely to:

A. a flat fee.
B. performance.
C. the owner's demand.
D. the employee's demand.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-83
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
77. If we reduce performance-based rewards to CEOs, the profits of firms will:

A. rise.
B. fall.
C. remain constant.
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

78. Which of the following is an outside incentive that forces managers to put forth maximal
effort?

A. Incentive contracts
B. Performance bonuses
C. Flat fees
D. Reputation

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

6-84
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
79. The cost to a manager of doing a poor job running the firm is:

A. a decrease in his fixed salary.

B. a decrease in the profit of the firm.
C. a decrease in the sales of the firm.
D. an increase in the likelihood of being replaced.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

80. Which of the following is NOT a solution to the manager-worker principal-agent problem?

A. Sales sharing
B. Piece rates
C. Fixed hourly wages
D. Spot checks

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

81. A profit-sharing pay scheme:

A. increases both productivity and profits.

B. decreases productivity but increases profits.
C. increases productivity but decreases profits.
D. decreases both productivity and profits.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-85
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
82. One problem with revenue-based incentive schemes is they do NOT provide an incentive
to:

A. maximize profit.
B. maximize sales.
C. minimize costs.
D. maximize productivity.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

83. A potential problem with paying workers based on a piece rate is that:

A. effort cannot be expended engaging in quality control.

B. effort should not be expended engaging in quality control.
C. workers will attempt to produce quality at the expense of quantity.
D. workers will attempt to produce quantity at the expense of quality.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
84. Which of the following is NOT a benefit associated with producing inputs within a firm?

A. reduction in transaction costs.

B. gains of specializing.
C. reductions in opportunism.
D. mitigation of hold-up problem.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 3 Hard
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

85. In order for spot checks to work:

A. employees must be monitored continually.

B. the time of the checks must not be predictable.
C. Both employees must be monitored continually and the time of the checks must not be
predictable are correct.
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

6-87
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
86. Which of the following involves the most risk from the point of view of the employee?

A. Piece rate
B. Profit sharing
C. Hourly wage
D. Annual salary

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

87. Long-term contracts are generally preferable to:

A. spot markets.
B. short-term contracts.
C. vertical integration.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

6-88
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
88. Which of the following is the primary disadvantage of producing inputs within a firm?

A. Increases in transaction costs

B. Loss of specialization
C. Reductions in opportunism
D. Mitigation of hold-up problems

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 3 Hard
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

89. Which of the following involves the LEAST risk from the point of view of the employee?

A. Piece rate
B. Profit sharing
C. Revenue sharing
D. Annual salary

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
90. Spot markets are generally preferable to:

A. long-term contracts.
B. short-term contracts.
C. vertical integration.
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

91. Which of the following forms of payment is NOT an incentive plan?

A. Commission plans for salespeople

B. Paying waitresses low wages, but allowing them to collect tips
C. Bonuses for managers that increase with profits
D. Straight hourly wages for construction workers

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

92. A positive side of long-term contracts is:

A. low transaction costs.

B. a loss of flexibility.
C. the continual need to renegotiate the contract.
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
93. Spot markets are an INEFFICIENT way for the firm to purchase inputs if:

A. opportunism is a problem.
B. suppliers engage in hold-up.
C. profit sharing is used to compensate managers.
D. opportunism is a problem and suppliers engage in hold-up.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

94. The activity known as shirking is LEAST likely to occur when:

A. workers are not monitored.

B. the earnings of a worker are closely tied to the worker's output.
C. all workers are paid the same wage rate.
D. firm ownership is separated from the managerial control.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
95. Suppose compensation is given by W = 450,000 + 220 π + 15S, where W = total
compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in
millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 6.0 percent
B. 7.9 percent
C. 12.6 percent
D. 43.4 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

96. Revenue sharing tries to induce worker effort by linking:

A. worker compensation to profits.

B. worker compensation to revenues.
C. worker output to profits.
D. worker output to revenues.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
97. A potential problem with piece-rate plans is that:

A. workers will have a tendency to under-produce the good.

B. workers have no incentive to work hard.
C. workers may put little emphasis on the quality of the good.
D. it is difficult for managers to enforce.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

98. Which type of compensation method does NOT involve a performance bonus?

A. Profit sharing
B. Revenue sharing
C. Piece rate
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
99. Which of the following is NOT a transaction cost associated with using inputs?

A. Time spent negotiating labor contracts with union workers

B. Opportunity costs of negotiating the price of renting machines
C. Wages paid to labor
D. Costs of searching for a new supplier of machines

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

100. As firms increase in size, they tend to experience a:

A. decrease in the need for managers.

B. decrease in transaction costs.
C. loss of opportunity cost.
D. None of the answers are correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
101. Suppose a firm manager has a base salary of $75,000 and earns 1.5 percent of all profits.
Determine the manager's income, if revenues are $10,000,000 and profits are $5,000,000.

A. $75,000
B. $150,000
C. $225,000
D. $300,000

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

102. Given that the income for a franchise restaurant manager is directly tied to profits, while
the income for the manager of a company-owned restaurant is paid a flat fee, we might
expect profits to be:

A. lower in franchise restaurants.

B. higher in franchise restaurants.
C. equal in both types of restaurants.
D. Profit comparisons cannot be made based on the given information.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

6-95
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
103. Generally, revenue-based incentive schemes:

A. reduce incentives to produce low-quality products.

B. increase incentives to minimize costs.
C. reduce worker productivity.
D. reduce incentives to produce low-quality products and increase incentives to minimize
costs.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

104. Which of the following is an outside incentive that forces managers to put forth maximal
effort?

A. Revenue-sharing contracts
B. Performance bonuses
C. Threat of takeovers
D. Flat fees

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

6-96
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
105. Point A in the figure below is:

A. efficient since it produces 20 units of output at the lowest possible cost.

B. efficient since it produces 10 units of output at the lowest possible cost.
C. inefficient since it produces 20 units of output at a cost greater than the minimum cost.
D. inefficient since it produces 10 units of output at a cost greater than the minimum cost.

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

6-97
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
106. Point B in the figure below is:

A. efficient since it produces 20 units of output at the lowest possible cost.

B. efficient since it produces 10 units of output at the lowest possible cost.
C. inefficient since it produces 20 units of output at a cost greater than the minimum cost.
D. inefficient since it produces 10 units of output at a cost greater than the minimum cost.

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

6-98
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
107. Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100
and the marginal cost of that contract is $50. Based on this information, the optimal
contract length should:

A. be increased.
B. be decreased by half.
C. be decreased by two-thirds.
D. be held constant at the contract length where MB = 100 and MC = 50.

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
108. Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100
and the marginal cost of that contract is $150. Based on this information, the optimal
contract length should be:

A. increased by half.
B. increased by two-thirds.
C. decreased.
D. held constant at the contract length where MB = 100 and MC = 150.

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

6-100
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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
109. Refer to the figure below. Suppose that the marginal benefit of writing a contract is $100
and the marginal cost of that contract is $100. Based on this information, the optimal
contract length should be:

A. increased by half.
B. increased by two-thirds.
C. decreased.
D. held constant at the contract length where MB = 100 and MC = 100.

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
110. Suppose a new contracting environment that requires greater specialized investments is
considered. This new contract will result in:

A. an increase in the marginal benefit and a longer optimal contract.

B. an increase in the marginal benefit and a shorter optimal contract.
C. a decrease in the marginal benefit and a longer optimal contract.
D. a decrease in the marginal benefit and a shorter optimal contract.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

111. Suppose a new contracting environment that requires less specialized investments is
considered. This new contract will result in:

A. an increase in the marginal benefit and a longer optimal contract.

B. an increase in the marginal benefit and a shorter optimal contract.
C. a decrease in the marginal benefit and a longer optimal contract.
D. a decrease in the marginal benefit and a shorter optimal contract.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
112. Suppose a new contracting environment that requires clearing fewer legal hurdles is
considered. This new contract will result in:

A. an increase in the marginal cost and a longer optimal contract.

B. an increase in the marginal cost and a shorter optimal contract.
C. a decrease in the marginal cost and a longer optimal contract.
D. a decrease in the marginal cost and a shorter optimal contract.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

113. Suppose a new contracting environment with an economic environment that looks more
uncertain is considered. This new contract will result in:

A. an increase in the marginal cost and a longer optimal contract.

B. an increase in the marginal cost and a shorter optimal contract.
C. a decrease in the marginal cost and a longer optimal contract.
D. a decrease in the marginal cost and a shorter optimal contract.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
114. The presence of substantial specialized investment relative to contracting costs suggests
that the optimal input procurement method is:

A. spot exchange.
B. vertical integration.
C. contract.
D. vertical integration or contract.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

115. The presence of minimal specialized investments relative to contracting costs suggests
that the optimal input procurement method is:

A. spot exchange.
B. vertical integration.
C. contract.
D. vertical integration or contract.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
116. EFI Conveyor Systems recently visited a local AC motor distributor. This transaction most
likely involves:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

117. Sydney Roofers Incorporated recently purchased 100 pounds of standard roofing nails from
Lowes, a nationwide hardware and building supplies store. This transaction most likely
involves:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
118. General Motors purchased Fischer Auto Body to produce bodies to place on a chassis. This
transaction is best described as:

A. spot exchange.
B. vertical integration.
C. contract.
D. contract or vertical integration.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

119. Which of the following is NOT an implication of specialized investments that lead to
increased transaction costs?

A. Costly bargaining
B. Opportunism and the hold-up problem
C. Underinvestment in specialized investments
D. Incentive contracts

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
120. Piece rates are typically a solution to the:

A. manager-worker, principal-agent problem.

B. manager-owner, principal-agent problem.
C. owner-worker, principal-agent problem.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

121. Time clocks are typically a solution to the:

A. manager-consumer, principal-agent problem.

B. manager-owner, principal-agent problem.
C. consumer-worker, principal-agent problem.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

122. Spot checks are typically a solution to the:

A. manager-consumer, principal-agent problem.

B. manager-worker, principal-agent problem.
C. consumer-worker, principal-agent problem.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
123. The threat of a corporate takeover is an _________ incentive that helps to mitigate the
_________ principal-agent problem.

A. internal; manager-worker
B. internal; manager-consumer
C. external; owner-manager
D. external; owner-consumer

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

124. Managerial reputation is an _____ incentive that helps to mitigate the _______ principal-
agent problem.

A. internal; manager-worker
B. internal; manager-consumer
C. external; owner-manager
D. external; owner-consumer

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

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125. A decrease in the marginal benefit arising from a specialized investment will cause the
optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

126. An increase in the marginal cost arising from a more complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
127. A decrease in the marginal cost arising from a less complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

128. Which of the following is NOT a solution to the manager-worker principal-agent problem?

A. Revenue sharing
B. Profit sharing
C. Time clocks and spot checks
D. The threat of a takeover

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
129. Which of the following is NOT a type of specialized investment?

A. Site specificity
B. Physical-asset specificity
C. Human capital
D. All of the statements associated with this question are types of specialized
investments.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 06-02 Identify four types of specialized investments; and explain how each can lead to costly
bargaining; underinvestment; and/or a "hold-up problem."
Topic: Transaction Costs

130. Long-term contracts become shorter:

A. when specialized investment becomes less important.

B. when the exchange environment is less complex.
C. when spot markets work poorly.
D. when marginal costs are increasing.

AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
131. An increase in the marginal cost arising from a more complex specialized investment
environment will cause the optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

132. An increase in the marginal benefit arising from a specialized investment will cause the
optimal contract length to:

A. increase.
B. decrease.
C. remain constant.
D. either increase or decrease.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
133. Suppose a firm manager has a base salary of $175,000 and earns 0.5 percent of all profits.
Determine the manager's income if revenues are $10,000,000 and profits are $5,000,000.

A. $150,000
B. $200,000
C. $225,000
D. $300,000

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

134. Suppose a firm manager has a base salary of $50,000 and earns 2.5 percent of all sales.
Determine the manager's income if revenues are $20,000,000 and profits are $5,000,000.

A. $50,000
B. $175,000
C. $550,000
D. $700,000

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
135. Suppose a firm manager has a base salary of $85,000 and earns 0.5 percent of all sales.
Determine the manager's income if revenues are $2,000,000 and profits are $500,000.

A. $50,000
B. $87,500
C. $95,000
D. $170,000

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

136. Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total

compensation of the CEO, π = company profits (in millions) = $300, and S = sales (in
millions) = $500. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 1.5 percent
B. 7.9 percent
C. 10.6 percent
D. 43.4 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
137. Suppose compensation is given by W = 500,000 + 200 π + 17S, where W = total
compensation of the CEO, π = company profits (in millions) = $400, and S = sales (in
millions) = $700. What percentage of the CEO's total earnings is tied to profits of the firm?

A. 2.0 percent
B. 13.5 percent
C. 19.6 percent
D. 31.4 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

138. Suppose compensation is given by W = 100,000 + 157 π + 12S, where W = total

compensation of the CEO, π = company profits (in millions) = $340, and S = sales (in
millions) = $700. What percentage of the CEO's total earnings is tied to sales of the firm?

A. 5.2 percent
B. 13.5 percent
C. 19.6 percent
D. 33.0 percent

AACSB: Analytic
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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139. By instituting performance-based rewards to CEOs the profits of firms will:

A. rise.
B. fall.
C. remain constant.
D. None of the statements is correct.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-05 Discuss three forces that owners can use to discipline managers.
Topic: Forces that Discipline Managers

Essay Questions

140. Determine whether the following transactions involve spot exchange, contracts, or vertical
integration.

a. A major oil company refines gasoline from crude oil produced by oil wells that it owns.
b. Transcontinental, an interstate natural-gas pipeline, has a legal obligation to purchase a
specified amount of gas per week from a well owned by Fred Smith in Enid, Oklahoma.
c. A cabinetmaker purchases a dozen wood screws from the local hardware store.
d. An electric utility purchases coal from an underground mine.

(a) Vertical integration; (b) contract; (c) spot exchange; (d) spot exchange or contract.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Discuss the economic trade-offs associated with obtaining inputs through spot exchange;
contract; or vertical integration.
Topic: Methods of Procuring Inputs

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
141. In general, automobile manufacturers produce their own engines but purchase tires from
independent suppliers. Why?

Engine manufacturing involves specific investments; by vertically integrating, the potential

for opportunism is reduced. Tires are more uniform and can usually be purchased by spot
exchange.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

142. Which of the following transactions are likely to result in relationship-specific exchange?

a. Purchasing gasoline for the company car

b. Hiring an employee to operate a machine that only your company uses
c. Buying napkins for the company snack bar
d. Purchasing coal for the factory furnace
e. Buying electricity

Certainly b, and in some instances, d.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
143. Explain how each of the following affects the optimal method of acquiring an input.

a. A complex contracting environment

b. A specialized investment
c. Opportunism
d. Bargaining costs
e. The costs of bureaucracy
f. Gains from specialization

a. Makes contracts a less attractive form of input acquisition.

b. Makes spot exchange problematic, due to opportunism.
c. Leads to more detailed contracts or vertical integration.
d. Leads to longer contracts, or in extreme instances, vertical integration.
e. Reduces the gains to vertical integration and lead firms to use contracts or spot
exchange to acquire inputs.
f. Reduces the benefits of vertical integration.

AACSB: Reflective Thinking

Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
144. Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound hamburgers in a
given week. To meet that demand, Jiffyburger needs 2,000 pounds of ground beef delivered
to its premises every Monday morning by 8:00 A.M. sharp. If you were the manager of a
Jiffyburger franchise, how would you acquire the ground beef? Explain.

I would use a contract, since this would decrease the problems of opportunism while still
allowing for specialization in production.

AACSB: Analytic
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
145. Explain why people in the following occupations are compensated as they are.

a. Insurance agents
b. Football players
c. Authors
d. CEOs of major corporations
e. Food servers

a. Insurance agents are usually compensated by a fixed base payment and a commission,
which is positively related to the amount of business brought to the company. Without the
variable part of salary, insurance agents have little incentive to find clients.
b. Football players are usually compensated by a fixed payment, along with incentives tied
to performance for reasons similar to the insurance agent example.
c. Authors typically receive royalties, which are revenue-sharing plans whereby the author
receives a fraction of the revenues generated by the book. This compensation scheme
provides the author an incentive to write a high-quality book in order to generate lots of
sales for the firm, and thus lots of royalty income for the author.
d. A CEO of a major corporation is usually compensated by a fixed payment plus a variable
bonus positively related to the amount of profits the corporation made. Without the variable
part of the payment, the CEO will not put forth as much effort as desired by the principal.
e. Waiters and waitresses are usually paid a small fixed payment by restaurants. The
majority of their pay is derived from tips, since customers can monitor their servers while
the restaurant manager cannot.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Learning Objective: 06-06 Describe the principal-agent problem as it relates to managers and workers.
Topic: Managerial Compensation and the Principal-Agent Problem
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
146. A manager derives satisfaction from income and leisure on the job (shirking).

a. If the manager is paid a fixed salary of $100,000, how much leisure will she consume on
the job during an eight-hour day? Explain.
b. When the manager is given a salary of $100,000 plus 10 percent of the firm's profits, she
chooses to spend six hours managing and two hours consuming leisure. Salary and bonus
total $120,000. Does the manager necessarily prefer this situation to the situation in part
(a)?

a. She will consume the whole eight hours as leisure because working (putting forth effort)
causes dissatisfaction to the manager. Hence the manager will shirk if there is no
punishment for doing so.
b. The manager does prefer this situation to the situation in (a). There are two
consumption bundles now: (1) $100,000 salary plus eight hours of leisure a day, and (2)
$120,000 salary plus two hours of leisure a day. Since the original choice of eight hours
shirking and $100,000 is still available, the fact that she chose to work two hours reveals
that she prefers the second pay scheme.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
147. Is it necessarily in the best interests of shareholders for management to ensure that there
is absolutely no shirking in the workplace? Explain.

Ensuring absolutely no shirking in the workplace implies very high monitoring costs. There
is a trade-off for shareholders between increasing productivity by reducing shirking and
reducing the monitoring costs. The manager should reduce shirking to the point where the
marginal benefit from reducing shirking equals the marginal cost of reducing shirking.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

148. Discuss the benefits and costs of the following methods of monitoring worker performance:

a. Hidden video cameras in the workplace.

b. Time clocks.
c. Paying workers based on the output they produce.

a. The benefits are that it may be effective. The problem is that it affects the morale of the
workers. Moreover, extra employees are required to watch the video.
b. The major benefit of using time clocks is that they verify that workers show up to work.
However, they do not provide any incentive to work once the workers are at the workplace.
c. The benefits are that the manager can know the performance of individuals. The costs
are that it may be costly to do so, and when the output is completed by teamwork or quality
is hard to evaluate, it is difficult to know an individual worker's performance.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
149. According to Industry Week, a shoe manufacturer recently had a production run that
resulted in 100,000 pairs of defective shoes. Workers on the production line knew the
shoes were defective as they were being produced, but did nothing to fix the problem. Do
you think a profit-sharing plan for workers would mitigate future problems? Explain.

Clearly a profit-sharing reward scheme would have provided workers with an incentive to
stop production. The bottom line is that if managers want workers to produce quality
products, they must structure rewards that promote that goal.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

150. College Retirement Equities Fund (CREF) is a pension fund that has billions of dollars
invested in the stock market. Fund participants recently voted on a proposal that would
have placed strict limits on the amount of compensation paid to CREF executives. Why do
you think 75 percent of the participants voted against the proposal?

To the extent that the compensation paid to CREF executives is performance-based,

executives receive large payments only if they are successful in increasing the net asset
value of CREF funds. Capping compensation would thus reduce the executives' incentive to
maximize the value of CREF funds, thereby reducing the overall return to the fund
participants.

AACSB: Analytic
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
151. Suppose a principal knew with certainty the level of profits that would result if an agent put
forth maximum effort.

a. Would there be a principal-agent problem?

b. Devise two incentive contracts that would induce the manager to put forth maximum
effort in this instance.

a. There would not be a principal-agent problem if the principal could devise a contract
such that the agent has no incentive to shirk.
b. Incentive Contract 1: Pay the manager a percentage of profits, provided profits are
maximal. Otherwise, pay nothing to the manager.
Incentive Contract 2: The manager is paid a fixed salary if the profit reaches the maximal
profit; the manager is paid nothing otherwise.

AACSB: Analytic
Blooms: Create
Difficulty: 3 Hard
Learning Objective: 06-04 Describe the principal-agent problem as it relates to owners and managers.
Topic: Managerial Compensation and the Principal-Agent Problem

152. Dallas-based Southwest Airlines recently announced a 10-year contract that gives pilots a
greater opportunity to share in the profits of the airline. According to the terms of the
contract, the pilots will receive options to buy 14 million shares of the firm's stock over the
next 10 years. What impact do you think this new contract will have on Southwest
Airlines?

The contract provides pilots an incentive to take actions that will enhance Southwest Air's
profits. Pilots will thus be more likely to strive for on-time departures, smooth flights, and
to be courteous to passengers.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
153. Art-R-Us makes hand-painted art reproductions. The owner-manager wishes to hire
another artist, and is considering paying a fixed wage plus either (1) a share of the profits
from each painting sold or (2) a fixed payment for each piece produced. Which plan would
you choose if you were the owner? Explain.

A share of the profits from each painting sold. Unlike a piece rate, this would provide the
artist a greater incentive to produce high-quality reproductions.

AACSB: Analytic
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

154. In a 1998 press release, Boeing Commercial Airplane Group (BCAG) announced that it was
signing a 10-year contract with distributor Thyssen Inc., a distributor of raw aluminum,
valued at approximately $300 million. The contract reflected Boeing's effort to reduce costs
and production bottlenecks resulting from supply shortages. The contract specified prices
and guaranteed quantities of raw aluminum to be delivered to BCAG's suppliers. If you
were the production manager at BCAG, how would you justify the long-term nature of the
contact with Thyssen Inc.?

A contract permits it to avoid the hold-up problem in the future, but the trade-off is the
uncertainty of the future economic environment.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
155. As a manager of the WeDoWell Corporation, you have negotiated with several vendors and
are on the verge of signing an eight-year contract with Bolts Enterprises. Under the
contract, they would ship to you 2,000 titanium bolts per month at a price of $1,000 per
bolt. Your assistant has just brought you an article from a trade publication that indicates
another company has developed a new technology that reduces the cost of producing the
titanium bolts. How would this information affect the optimal length of your contract with
Bolts Enterprises? Explain.

The reduction in another supplier's cost of producing titanium bolts reduces WeDoWell's
marginal benefit of contracting. Therefore, the eight-year contract it has been negotiating
is too long; the optimal contract length is now less than eight years.

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-03 Explain the optimal manner of procuring different types of inputs.
Topic: Optimal Input Procurement

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
156. At the recent shareholders' meeting, the CEO of a small bank proposed a plan to offer each
of its employees 250 incentive options for Class A common stock. The key provisions of the
plan are that employees must exercise the options between January 2014 and December
2019, and if an employee terminates his or her employment with the bank (or is
terminated), the options are no longer exercisable. One shareholder feverishly objected to
the plan, claiming that such a move would dilute the value of the outstanding shares. As
CEO, how would you defend the stock option plan to the shareholders?

The first important point to make with the shareholders is that this incentive plan is
designed to maximize shareholder value. This is achieved by giving employees an incentive
to stay with the company longer, thereby reducing costly employee turnovers and
increasing the company's profitability. Also, by using the stock options as an incentive plan,
employees will want to find ways to work more productively and make the company more
profitable. The benefits to the shareholders and the employees will be a higher stock price.

AACSB: Analytic
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
157. You are the manager of Door-to-Door Vacuum Cleaners, Inc. Each salesperson is paid a
base salary plus a percentage of the revenues she or he generates. In addition, each
salesperson drives his or her car to and from each sales call and is reimbursed $0.40 per
mile driven. On average, each salesperson drives about 150 miles per day and 240 days per
year. As manager of Door-to-Door, how might you restructure the compensation of your
sales force to enhance your profits? Are there any potential disadvantages of your plan?
Explain.

The manager might pay a salesperson a base salary plus a percentage of the profits. This
plan would penalize salespersons, to some extent, for excessive mileage.

AACSB: Analytic
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss four tools the manager can use to mitigate incentive problems in the workplace.
Topic: The Manager-Worker Principal-Agent Problem

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.