EC2212 INDUSTRIAL GROWTH AND COMPETITION

Section A:

Answer ALL questions in this section.

For each of the following, are they a moral hazard, adverse selection, or hold up problem? Explain why.

1. A firm is considering providing all employees with a phone so that it will be easier for them to answer work e-mails. However, the firm is worried that the employees may use the phones to browse the internet or play games, instead of focusing on work e-mails. Furthermore, privacy laws prevent the firm from installing spyware or controls on the phone. (6 Marks)

2. A new start-up fintech firm is offering loans of up to £10,000 without checking credit and with an above-market interest rate. They figure that they will increase their profits by charging higher interest and avoiding credit bureau expenses. (6 Marks)

3. In order to offer the loans, the fintech firm discussed above, has to work with a traditional bank which has sufficient deposits in order to fund the loans. They are considering working with HSBC or Barclays. HSBC has a different accounting system and Barclays has a different compliance system. So, in order to work with HSBC, the firm will have to update its accounting system or to work with Barclays, the firm will have to update its compliance system. (6 Marks)

4. Joanna’s son has graduated university and is starting a new job in a far away city. Joanna is considering getting him a dog, which is something that he has wanted for a long time. However, her son’s apartment is small and Joanna thinks that he should take the dog for a long walk each day. (6 Marks) 5. Harry is considering buying a used bicycle. The price seems very reasonable, but Harry does not know much about bicycles. (6 Marks)

(Total 30 Marks)

Section B:

Contracts Answer THE ENTIRE question in this section.

1. A firm writes a contract for an employee to work on a specific project. If the project is successful, then it yields $40000 to the firm. If the project is unsuccessful, then the firm receives $0. If the employee puts in a high level of effort, then the project is successful with probability 80%. If the employee puts in a low amount of effort, then the project is successful with probability 55%. The employee’s cost of high effort is 100. The employee’s cost of low effort is 0. The employee’s outside option is 1000. The employee is risk-neutral.

(a) Suppose that the principal offers a bonus of $1000. Would the employee put in a high level of effort, or a low level of effort? (4 Marks)

(b) Is this an incentive constraint or a participation constraint? (2 Marks)

(c) What is the minimum bonus that the firm must offer the employee for her to put in a high level of effort? (4 Marks)

(d) Assume that the firm offers the bonus that you found in part (c). What is the minimum fixed wage that the firm can offer so that the employee will work for the firm? (6 Marks)

(e) Is this an incentive constraint or a participation constraint? (2 Marks)

(f) Suppose that the firm offers the bonus and fixed wages that you found in parts (c) and (d). What are the firm’s expected profits? What is the employee’s utility? (6 Marks)

(Total 24 Marks)

Section C:

Externalities Answer ALL questions from this section.

1. John is opening a restaurant on the ground floor of a building. Residents of the lower floors of the building suffer externalities due to noise of $20000 as they are close to the restaurant. Residents of the upper floors of the building enjoy positive externalities of $10000 as they have a new dining option which is very close by. John expects to make a profit of $30000.

(a) Is opening the restaurant efficient? Yes or no, and why? (4 Marks)

(b) Residents of the lower floors can move to different buildings. Suppose this costs them $60000. Is it efficient for them to move? (4 Marks)

(c) Suppose that the restaurant can install sound-proofing which costs $15000 to do so. Is it efficient for the restaurant to sound-proof itself? (4 Marks)

(d) According to whom, if there are no transaction costs and parties are free to bargain, then the efficient solution should take place. (3 Marks)

(e) Suppose that property rights are with John. Who pays for the efficient solution? (4 Marks)

(f) Who is the least-cost avoider? Therefore, who should have the property rights to minimize transaction costs? (4 Marks)

(Total 23 Marks)

Section D:

Corporate Finance Answer ALL questions from this section.

1. Your manager is considering undertaking a new project. In the following table are the payoffs of that specific project. The cost to a company for undertaking this project is $1000. The interest rate is R = 5%. Should you advise your manager to take the project? Why or why not? (6 Marks)

2. Firms A and B participate in the same project and share the proceeds evenly. Neither firm has any other projects. Firm A has a debt of $1 million and 100000 shares outstanding. Each Firm A share is worth $50. Firm B has 50000 shares outstanding and no debt. How much is each share of B worth? Whose theorem did you use to calculate this? (8 Marks)

3. Do firms in the US or Japan offer lifetime employment? (3 Marks)

4. Who uses more suppliers, GM or Toyota? (3 Marks)

5. Which country uses non-monetary incentives? (3 Marks)