*** Instructions ***

Final Examination, Organizational Economics, BEM/Ec 146

Prof. Colin Camerer

Winter 2006

Work alone. Spend no more than eight hours on this exam. (I hope that amount of time is generous but some of the questions require real thought and I would like you to have the time to write carefully rather than dumping hippocampal core.) You can stop and start the 8-hour clock provided you do not consult materials or discuss the exam during breaks. This is an open-book/notes exam. Any materials handed out or available on the class website, or lecture notes from this term of your own or from other students, can be consulted throughout the exam. No other materials may be consulted.

Read the entire exam before you start. Allocate effort sensibly based on points. Think before you write! Limit your answers (because being able to think compactly is useful). For each 5 point question, write no more than 200 words or half a page (using 1.5 line spacing and 12-point font). For other point totals, these limits scale linearly (e.g. 400 words or a full page for a 10 point question). The point totals also signal to you the maximum depth of thought that is expected.

The exam is due at noon on the 17th of March. You can email it to me or Noah Myung (noah at hss.caltech.edu), or hand it in to my mailbox in the 1st floor of Baxter, or to Melissa Slemin at 332 Baxter. Ensure that your name is written on top of each page. When emailing Noah, please write “BEM 146, Final Exam, Student name” on the subject line.

Thanks for your engagement and patience w/ erratic distribution of text materials in lieu of a real textbook.

*** End of Instructions ***
1. Point-shaving in college basketball (forensic economics). “Point shaving” refers to a practice in which players deliberately do not score as many points as they could, in order to harm their own team. The theory is that such episodes occur—if they do at all—to earn money for gamblers (and payments or winning bets for the players themselves). A key point is that basketball gambling usually establishes a point spread (e.g., UCLA favored by +6). If the team wins by more than the spread, then betting on them to “beat the spread” wins you money. If the team wins, but wins by less than the spread, or loses, then your bet loses. (If they win by exactly the spread the bet is a “push” and nobody wins.)

(a) (10 points) Suppose that some people (e.g. nongamblers) pay the most attention when a game is close and pay less attention when the game is not close. And suppose that paying a lot of attention increases the chance that fans and TV watchers become suspicious about point shaving. If there is point shaving, in what sorts of games do you expect it to be most common?

(b) For most colleges, only a small percentage of players get drafted and become pro players. Furthermore, in many colleges only a modest percentage of scholarship athletes even graduate (around a half in football). Those who don’t graduate usually have poor job prospects, and suppose a scandal would be most damaging to them. Suppose that if a player is likely to be good enough to go pro, being caught point shaving would be very damaging to their career. If point shaving occurs, where do you expect it to be more common: (5 points each)

i. Teams with many potential pro players or teams with few potential pro players

ii. Teams with likely potential graduates or teams with few likely graduates.

2. A March 11, 2006 LA Times article about day laborers (”Labor Center Shunned for Higher Pay on the Street”) reports some interesting observations about spot markets for unskilled labor. The article describes how a job center in Orange, CA “places about 15 of the 20 or so job seekers who come in every day”. Most day laborers do not come to the center; instead, they congregate around parking lots where employers look for them. The article reports: “Day laborers say job centers, many of which have preset wages and a first-come, first-served policy, can be restricting. They [the workers] prefer dealing directly with the employers and negotiating rates.” (Keep in mind that there is an excess supply of workers.)

Think like a political economist.

  1. (5 Points) What are the likely incentives of the people who manage job centers? That is, what are the criteria on which they are evaluated (or choose to promote). Do they want to brag about how many workers arrive, or how many are placed? Do they care if workers are paid a lot or a little?
  2. (10 Points) Are the job center’s wages likely to be above or below the wages that workers “prefer” to negotiate? (Ask what you would expect to see if the job center’s wages were higher than the typical negotiated wage? What would you expect to see if the center’s wages were lower? What would the employers who drive around in trucks looking for workers be most likely to do?

3. Caffeine smackdown:Starbucks is largely responsible for the boom in creating expensive “designer” coffee. (Before Starbucks, coffee was basically a commodity sold in retail stores and per cup with not too much variation in prices.) Now McDonald’s has taken on Starbucks by offering premium dark-roasted coffee, which they are heavily promoting.

a. (5 points) One of their promotions is “2 for 1” coupons which give a free cup second cup if you buy one cup. What market segment do these promotions target?

b. (25 points) Suppose you were a consultant for Starbucks. What five questions would you ask to determine how much of a competitive threat McDonald’s is to you? (Note: This is the kind of question you are often asked in a consulting-firm interview. There is no clearly right answer. You will be graded on the quality of your ideas and thought.)

4.Economic justice?Parade magazine reported (12 March 2006), in its annual cover story on how much people earn, that Supreme Court Chief Justice John Roberts earns $212,000 per year and pre-teen child actress Dakota Fanning (who was in “War of the Worlds” and some earlier films) earned $15 million per year.

a. (12 points) Assume the labor markets are in equilibrium and people are paid their marginal revenue product (or equivalent social value for government employees). List four factors that could justify such a wage differential.

b. (12 points) Perhaps labor markets are not in equilibrium. Then either supply will change to allocate more labor to high wage jobs: John Roberts will quit to pursue an acting career, Dakota Fanning’s salary will fall, or John Roberts’s salary will increase. What four events could take place to cause such changes? (Note, this is essentially the opposite of your answer to (a); list some factors which would justify wages being out of equilibrium.)

5. (5 points each) Define each term, and give an original example not mentioned in class or in the text material:

  1. Compensating differential
  2. Five forces
  3. “Hold up” risks from relationship-specific investment
  4. Corporate culture
  5. Democratic versus dictatorial boards [no example needed]
  6. Influence costs

6. (5 points)Stock versus cash:Most studies indicate that acquisitions which are financed by swapping the acquiring company’s stock for the target company are less valuable to the acquiring firm (in terms of immediate stock return) than acquisitions which are financed with cash. Why?

7. Tournaments: In the theory of tournaments, players choose effort levels ei0 (i.e. e1 and e2). Each person’s output is measured by ei plus some random luck (or measurement error) term xi. In a two-person tournament, the person with the highest total wins a fixed prize H and the person with the second-highest total wins L. If they tie they win (H+L/2) each.

Suppose the luck components are independent and identically distributed with a uniform distribution over [-e, + e] (i.e., the partial distribution function f(x)=1/(2e) for –exe and f(x)=0 elsewhere). And suppose the cost of effort is c(e)=be^2.

  1. (5 points) First compute the probability that player 1 wins if efforts are e1 and e2. (Hint: Compute the distribution of the difference in the two luck components. The sum of this difference and e1-e2 is what is crucial, because if (e1+x1)-(e2+x2) is positive then player 1 wins).
  2. (10 points) Now assume that players are optimizing by maximizing the expected chance of winning the big and little prizes (H and L) and subtracting the cost of effort. Solve for the symmetric equilibrium in which they both exert the same effort e*. (That is, find the effort e* which balances marginal benefits from improving the probability of winning, and marginal cost c’(e)).
  3. (2 points each) How do the equilibrium efforts in (b) change if the amount of luck goes up (e goes up) and if the prizes change?
  4. Discrimination: Now suppose that player 1 has an advantage A (where 0A2e). The advantage means that player 1’s total perceived output is measured as e1+x1+A. So even if her total output e1+x1 is less than A units less than player 2’s, she still wins (if player 1 is exactly A units worse than they are tied). Compute the equilibrium efforts for player 1 and player 2 for this case.
  5. (15 points) How does an increase in A affect the two player’s efforts?
  6. (3 points) Give an intuitive explanation for the result you derived in (1).
  7. (3 points) If you were running a firm and trying to get the most effort from workers, what value of A would you pick (holding e and b constant)?

8. Up-or-out. Some specialized labor markets have a system called “up or out”. In this system, there is a fixed promotion schedule. If you do not get promoted at a certain critical point, then you *must* leave (you’re “out”). Tenure in universities is exactly like this.

  1. (5 points) An alternative system is no tenure. Then professors are evaluated periodically and can be fired if a review by some kind of faculty committee leads to the conclusion that they are not fulfilling agreed-upon goals. What drawbacks would this system have for academics?
  2. (5 points) Another alternative system is tenure with exceptions. Then people who do not get tenure could go onto some kind of “non-research track” and stay at the university, but do some other bundle of tasks with periodic evaluation. What drawbacks would this system have for academics?

9. Executive compensation:Describe three of the six challenges in creating good motivational executive compensation discussed by Brian Hall. (5 points each)

10. Please let me breathe in carcinogens: (10 points)Government agencies (typically OSHA, the Occupational Safety and Health Agency), regulate workplace safety. In some cases, workers actually object when OSHA requires their employer to make the workplace safer. Why would workers who have been working somewhere for a while object to having it made safer? (Hint: Think like an economist.)

11. Hmm.(10 points) A recent radio commercial says “You shouldn’t have to pay more for a loan just because you have bad credit”. Discuss.