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					                        INCENTIVES AND CONTRACTS
                               1st Term 2000
                                    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 two 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: 120 minutes

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

                  This exam has 5 pages including the coversheet.

                                        PART A

Answer the following questions in relation to the Bentley Clothing contract handed out in
class and reproduced on the following page:

   (a) There are two elements to the contract: (1) Design and (2) Sales. Describe in
       detail the structure of Susan’s incentives in each stage of the contract.

   (b) What risks does Bentley face in the Design stage of the contract? What elements
       of the Sales stage mitigate these risks?

   (c) What risks does Bentley face in the Sales stage of the contract?

   (d) If there are potential problems with the incentives in the contract, what factors
       might you change to improve these? Clearly state the costs and benefits of your
       proposed changes.

                                                Bentley Clothing

cc: Willy

Dear Marvin:

The following is a summary of our meeting on July 26, 1995 regarding our future relationship. I hope you
share my enthusiasm about the opportunities to join Bentley as a consultant to develop new clients, and
continue growth of your sleepwear and daywear business. As detailed, my responsibilities will be directed
toward developing a client presentation, product line, and strategy to fully maximize Bentley’s strengths.
Design and production of both sleepwear and daywear would be the first stage in the endeavor. For this
effort (estimating 8-10 working days) a fee of $700.00 per day will be paid. In September, I will begin
contacting clients with the prepared presentation to generate interest and sales in Bentley’s product line. I
will do so under the name of Apparel Concepts and Resources.

For the on going development of clients, the consultant fee of $500.00 per day will apply. There will be an
additional resource assistant hired to support my efforts once I relocate to Atlanta. This person will be paid
an approximate cost of $25,000 annually. It’s our mutual goal to fully develop and maximize Bentley and
ACR as a relationship. To do so, Bentley will provide all back-end production management and sources to
support the customer sales and orders. It is my intent to fully develop the customer relationship and generate
sales for sleepwear and daywear. It is agreed that Bentley will provide these consulting fees and support
resources for a period of one year from the first market entry. A commission based relationship for 7-8% of
gross sales will replace the consultative relationship at the time when commissions exceed the consultant

                   $5,600-$7,000 - Market Preparation
                   $18,000 - 3 Days Per Week @ $500.00 Per Day for 12 Weeks
                   $100,000 - 5 Days Per Week for 40 Weeks

                   $118,000 - Sales & Marketing Effort Per Year
                   $25,000 - Assistant
                   $143,000 - Grand Total

                   Margin = 30% on these clothes.

It is understood that travel expenses and associated office expenses will be paid by Bentley for the first
year. Prior approval for expenses will be requested if they are of significant nature. A weekly report of
expenses will be sent, to be certain that we don’t lose sight or get behind. To further assure the working
relationship is a successful one, I propose to send a weekly recap or summary to you each Friday. Any
questions or opportunities can be discussed in advance and be fully optimized.

I hope this letter reflects your understanding, as it is my interest to be working together for the future.


                                                 PART B

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

QUESTION 1: Brand Names

Klein, Crawford and Alchian state:

         “One ... asset that is almost always owned by the firm is its trade-name or
         brand-name capital and, in particular, the logo it uses to communicate to
         consumers. If this asset were rented from a leasing company, the problems
         would be obvious. Although these problems seem insurmountable, rental
         of the capital input of a firm’s brand name is not entirely unknown. In fact,
         franchisers can be thought of as brand-name leasing companies.”
         (Source: “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,”
         Journal of Law and Economics, Vol.XXI, No.2, October 1978)

   (a)       Why can a brand name be viewed as an organization-specific asset?

   (b)       In a complete contracting world, what types of controls would a brand-name
             owner need to place on others in order to preserve the brand-name’s value?

   (c)       What types of risks do brand-name owners face in a world of incomplete

   (d)       Why might brand-name owners wish to lease out their brand names through a
             franchise agreement?

   (e)       Explain how a franchise relationship may provide an appropriate balance
             between contractual risks and incentives placed on franchisees.

QUESTION 2: Supply Contracts in Car Manufacture

Universal Motors produces cars. It has asked the Australian Fabric Company to consider
a proposal to become a supplier of car seats. Under the proposal, Australian Fabric would
construct a $20 million plant near one of Universal’s production facilities. Universal
would purchase 100,000 car seats per year at a price of $280 per seat for 15 years – the
useful life of the plant.

Australian Fabric’s financial analysts have examined the proposal. It appears to be a
profitable opportunity. The amortized cost of the plant is $2.6 million per year (at a
discount rate of 10 percent). The annual costs are $25.4 million per year. Therefore, the
average total cost is $280 per seat – ATC = ($25.4 million + $2.6 million)/100,000 =
$280. The financial analysts have examined Universal’s financial outlook. While it has
not been highly profitable in all years, there is essentially no probability of bankruptcy
over the next 15 years. Since the proposed price covers the cost, the financial analysts
think that the proposal should be accepted. (It breaks even with a fair rate of return on
invested capital of 10 percent).

You have been asked to analyse the contract proposal. You have seen the financial
analysis and think the cost estimates are correct. You are aware that, due to its location,
the proposed plant has no alternative use other than supplying seats to Universal. The
salvage value of the plant, in the event of liquidation, is $2 million (i.e., amortised value
approx. $260,000 per year).

   (a)     Suppose that the contract price is potentially subject to revision if there is a
           “change in market circumstance.” If Universal were to renege on the contract
           once the plant is built, how much can the purchase price fall before Australian
           Fabric liquidates the plant.

   (b)     What factors would you consider to determine if opportunistic behaviour by
           Universal is a likely possibility?

   (c)     Does Universal have to worry about any opportunistic actions by Australian

   (d)     Discuss factors that might make it difficult to write a contract that would limit
           opportunistic behaviour by both companies.

   (e)     Discuss the costs and benefits of other solutions to potential hold-up faced by
           Australian Fabric and Universal.