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									                         INCENTIVES AND CONTRACTS
                                2nd Term 1999
                                    Joshua Gans

                                    Final Exam

 There are two parts to the exam: Part A and Part B. All of the questions in Part A are
compulsory while you may choose to answer one (1) from the three questions in Part B.
          Put all answers in the book provided. Each part is worth 30 marks.

  Note: consider your answers carefully. High grades will be awarded for clear and
                         concise reasoning and not length.

                               This exam is open book.

                              Reading Time: 15 minutes
                                Duration: 90 minutes

                                  Total Marks: 60
                        Total Weighting: 60% of subject grade

                   This exam has 6 pages including the coversheet.

                                       PART A

The following questions relate to the case – “McMullen and Worby (A) (Abridged)” –
distributed in class.

1. How is Holly‟s bonus determined? Is it based on objective or subjective measures?

2. What important variables does Holly control? What are the difficulties John and Anne
   face in directly observing those variables? Would they want to overcome these
   difficulties by monitoring?

3. John and Anne are having difficulty in determining Holly‟s performance because of
   the impact of the „Great Blizzard of ‟78.‟ Should they try and remove this from
   consideration? Why?

4. What difficulties do you envisage John and Anne will face in the future regarding
   incentives provided for their managers? What are the costs in providing incentives to
   decision-makers within an organisation?

                                          PART B

Choose one (1) of the following three questions. Do not answer more than one question.

QUESTION 1: Coal-Burning Electric Generating Plants

Among the many electric generating plants in the U.S. that burn coal, there is wide
variation in coal supply relationships. Roughly 15% of utility company coal is supplied by
mines that are owned by the utility. Another 15% of utility coal is purchased in the spot
market. The rest is purchased under contracts that vary in duration from one year to fifty

Coal plants vary in locational strategies (proximity to the coal reserves), plant design, and
transportation strategies. Most plants are built near customer service territories, and coal
is transported by truck or rail from the coal mine to the power plant. “Mine-mouth
plants,” however, are built adjacent to coal reserves, and power is then transported
through a high voltage transmission system to load centres. The sole-source supply of
coal that occurs with mine-mouth plants also encourages a plant design that is tailored to
burn a particular type of coal with maximum efficiency.

(a) Relative to coal plants that are built near service territories, are mine-mouth plants
    more or less likely to own the mines that provide the coal that is burned. Why?

(b) Relative to (non-vertically-integrated) coal plants that are built near service territories
    are (non-vertically integrated) mine-mouth plants likely to have longer-term or
    shorter-term contracts with coal suppliers? Why?

(c) Shifting gears slightly, why are labour union contracts typically of one to three years
    in duration, whereas mineral supply contracts, such as coal contracts described above,
    often span decades.

QUESTION 2: Independent versus In-House Research and Development

Because of their medical nature, the new products developed by biotechnology start-ups
will not have commercial value unless they pass through stringent regulatory approval
processes. These processes, not only take a long time (many years in cases), but require
the developer to undertake expensive testing procedures to determine their product‟s
safety. A few large pharmaceutical companies have become very proficient at obtaining
regulatory approval and the marketing of biotechnology products. They have achieved
this status by investing heavily in research, management and marketing resources in the

Suppose that you are an innovator and have formed a start-up company to develop a new
biotechnology product innovation. You know that if you succeed in developing this
innovation and the innovation passes regulatory tests it will have a value of $50 million to
any firm marketing it; above and beyond any costs associated with getting that regulatory
approval and marketing costs. This figure is the monopoly profits a firm could earn if it
owned the patent to the innovation.

The key inputs in generating this innovation are the effort of scientists in your team and
capital equipment. The effort of your team could be high or low while the capital
contribution required is $10 million. Given these inputs, the matrix of probabilities of
innovative success are given as follows:

                                                   Low High
                       Capital     None             0       0.1
                                   $10 million     0.2      0.5

The cost, in terms of lost alternative wages, of high effort from your team is estimated to
be $2 million. For low effort, there is assumed to be a zero opportunity cost.


QUESTION 2 (continued)

(a) From the perspective of maximising total value created, is it worthwhile to pursue the
    research and development project?

(b) Suppose that there is only a single pharmaceutical company who specialises in
    commercialising this type of innovation. Also suppose that you cannot raise the
    required capital and that the efforts of yourself and your research team are non-
    contractible. Finally, assume that you cannot feasibly commercialise the innovation
    yourself. What is the likely outcome under these assumptions? Describe your answer

(c) As an alternative, the pharmaceutical company could acquire your start-up prior to the
    commencement of the project. This would give it exclusive ownership rights to any
    innovation generated. Innovative effort remains non-contractible. What is the likely
    outcome in this scenario? Does this in-house case result in higher value created than
    the case of having an independent research unit?

(d) Suppose that a third party (or venture capitalist) could provide the $10 million in
    capital to your company. For this it requires some equity in your venture. How much
    equity will it require? What does this do to total value created?

QUESTION 3: In-House versus Independent Salespeople

Economists Erin Anderson and David Schmittlein studied the question of why industrial
selling is sometimes performed by in-house salespeople and sometimes by independent
representatives who also spend part of their time and energy selling the products of other
producers. The main variables explaining the choice between in-house sales agents and
independent representatives in a sales region were found to be the “difficulty of evaluating
performance” (for example, because the sales agent was part of a team and individual
contributions to the sales were hard to evaluate objectively) and the “importance of
[salespeople performing] non-selling activities” (such as assisting customers in resolving
product problems after the sale).
Use theories from this class, predict the effect of a change in each of above two factors on
the choice between in-house salespeople and independent representatives. Specifically:
(a)    Do we tend to observe more or less in-house salespeople as performance becomes
       more difficult to evaluate? Explain.
(b)    Do we tend to observe more or less in-house salespeople as the performance of non-
       selling activities conducted by salespeople becomes more important? Explain.


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