Ch.10 Incentive Conflicts and Contracts Test Bank Docx

Student name:__________

1) Jim Range owns an ice cream store, Best Ice Cream, one of 1,000 franchises across the country. Jim doesn't like to work evenings, so he hires Mary Jo Smith to work in the store in the evening for $7.25 per hour. Mary Jo's friends come by each evening and she gives them free cones. Is this an adverse selection problem or an incentive problem? What is the solution?

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

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

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

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

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

7) What is an agency relationship? What are agency problems?

8) What is adverse selection? Give an example to illustrate this problem.

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

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

11) Markets use prices to allocate resources, while firms use

A) cost-price ratios.
B) managers.
C) the board of directors.
D) random decisions.

12) The firm or corporation is the focal point for

A) a set of contracts.
B) the interaction of demand and supply.
C) dealing with asymmetric information.
D) value minimization.

13) Which of the following is not a problem in owner-manager or principal-agent conflicts?

A) choice of effort
B) perquisite taking
C) identical time horizons
D) differential risk exposure

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

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

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

A) the amount owners and the managers want to pay to the shareholders
B) the amount owners and the managers want to receive
C) the amount owners want to pay and the amount managers want to receive
D) the amount owners want to receive and the amount managers want to pay

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

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

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

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

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

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

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

A) signaling
B) bargaining
C) free-riding.
D) costless contracting

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

A) useless group leader
B) adverse selection problem
C) free-rider problem
D) buyer-supplier conflicts

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

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

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

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

23) Designing efficient contracts are costly when

A) there is perquisite involved.
B) there is complete information.
C) there is asymmetric information.
D) there is an agency relationship.

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

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

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

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

26) ________ makes designing efficient contracts costly.

A) Signaling
B) Self-selection
C) Huge monitoring costs for the principal
D) Huge monitoring costs for the agent

27) Monitoring costs are

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

28) In an agency relationship, the costs incurred by agents to ensure that a principal is compensated if they take any action that is detrimental to the principal is known as

A) monitoring costs.
B) bonding costs.
C) recurring losses.
D) residual losses.

29) Total agency costs are

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

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

A) minimized.
B) not maximized because more hours of services are provided.
C) not maximized because fewer hours of services are provided.
D) maximized.

31) Precontractual informational asymmetries that generate contracting costs can lead to

A) bargaining failures and adverse selection.
B) implicit contracts and reputational concerns.
C) explicit contracts and credibility issues.
D) perquisite taking and differential risk exposure.

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

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

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

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

34) Adverse selection in bargaining arises from

A) signaling private information to other parties.
B) self-selection based on private information.
C) implicit contracts between the principal and the agent.
D) asymmetric information held by the principal or the agent.

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

A) excessive high costs.
B) adverse selection.
C) incentives.
D) implicit contracts.

36) One of the ways of overcoming the problem of adverse selection is through

A) signaling.
B) bargaining.
C) free-riding.
D) costless contracting.

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

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

38) Which of the following is true of implicit contracts?

A) Enforcement depends on the private incentives of individuals.
B) Agents do not act in the best interest of principals.
C) The gains from trade are low and there are market failures.
D) The opportunity cost of residual loss is low.

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

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

40) ________ can provide incentives to honor implicit contracts.

A) Value maximization
B) Adverse selection
C) Reputational concerns
D) Bargaining power

41) It is in the interest of all parties to develop efficient solutions to agency problems through ________ so that more wealth can be shared among the contracting parties.

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

42) It is in the self-interest of individuals to

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

43) Incentive problems in contractual relationships generate

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

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

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