VILLANOVA UNIVERSITY
College of Commerce and Finance
MBA: Economics of Strategy
Dr. Peter A. Zaleski
Fall ’99: Mid-term Examination
Answer all questions on this document. SAVE the file as (#####)m99.doc where (#####)
denotes the first five letters of your last name. E-mail the completed exam back to me in
2 ½ hours. Good luck. The number in parentheses is the points allocated to the problem.
Use these numbers to budget your time. Your answers should appear BLUE
1. List and completely describe the benefits and costs of using the marketplace to obtain
the inputs needed to produce your company’s main output as opposed to making
those inputs yourselves. (15)
Answer:
Benefits: 1) Take advantage of Economies of Scale in the production of inputs
2) Subject the producers of those inputs to the discipline of the market place
Costs: 1) Leakage of Private Information, 2) Coordination Problems, 3) Transaction
Costs of Negotiating/Renegotiating with Suppliers
2. Of the costs and benefits listed above, which best explains why: (10)
a) Scott McNealy, CEO of Sun writes “Why We Don’t Want You to Buy Our Software”
(WSJ, 9-1-99)
b) General Motors purchased Fisher Body in the 1920’s.
c) MCI and Sprint plan to merge.
d) Large-scale marketing research studies by your company are typically performed by
outside suppliers.
e) Reader’s Digest (last year) sold all of its office buildings to a realty management firm
and then leased the office space back.
Answer:
a) Your supplier of automated services will use Sun software while you focus on what
you do best. Your software supplier, because they handle more programming than
you will, enjoy economies of scale.
b) Fisher feared being held up after making a relationship specific investment. This
transaction cost forced GM to buy Fisher.
c) They will argue Economies of Scale
d) Economies of scale. The outside supplier can spread fixed costs over many projects
e) Dare I say Economies of Scale again.
3. PICK TWO OF THE FOLLOWING: (15)
a) “Copper can be mined at a constant average cost of $10 per unit. The market price is
$18 per unit. Copper is an input to our primary product, pipes. Given this discrepancy
between the market price and what would be our internal cost, we should mine our
own copper.” Comment.
b) Compare the recent anecdotal evidence on diversification (Kelloggs/Lenders,
Quaker/Snapple, Purina/EverReady) with the statistical evidence offered in your text
regarding the motives behind and performance of mergers and acquisitions?
c) Define a complete contract versus an incomplete contract. List and explain two
factors that prevent complete contracting. Describe three of the various remedies
available to resolve contract disputes.
Answer:
a) Regardless, the opportunity cost of the internally produced copper is $18 – that’s
what you could sell it for. So, either way you’re giving up $18 to use the copper to
make pipes. So, the argument is irrelevant.
b) Diversified mergers tend to be unprofitable. As a means of spreading risk, they help
managers stay afloat, but shareholders could diversify on their own by owning the
shares in the two different company. Given the performance, managers are not good
portfolio managers.
c) See handout from Kuhn.
4. A firm produces two products, X and Y. The production technology displays the
following costs, where C(i,j) represents the cost of producing i units of X and j units
of Y for the current month:
C(0,50) = 100
C(10,0) = 320
C(5,0) = 150
C(5,50) = 240
C(0,100) = 210
C(10,100) = 500
Does this production technology display:
a) Economies of scale?
b) Economies of scope?
c) A Learning Curve?
Be sure to explain (15).
Answer:
a) Economies of scale: Holding x constant at 0, double Y from 50 to 100. C more than
doubles so Y does NOT exhibit economies of scale. Holding y constant, double X
from 5 to 10, C more than doubles so Y does not exhibit economies of scale.
b) Making 5,50 costs 240 when done together and 100+150 when done separately. There
are economies of scope.
c) Since these are all for the current month, there is not enough info to find learning
curve.
5. Historically, compensation for workers followed a “wage/tenure” profile in which a
worker’s wages tended to be low relative to her productivity when first hired, and
high relative to her productivity after the worker had remained with the firm for many
years. How might such a profile enable a firm to “hold-up” its workers? Be sure to
identify a source of quasi-rents. (10)
Answer: The worker’s wage next year will exceed what she is worth in the job market.
6. General Mills (GM) makes Cheerios breakfast cereal. Which of the following is GM
more likely to outsource and why: the growing and harvesting of raw oats OR the
baking of the O-shaped oats? Why?(10)
Answer: Growing and harvesting oats is not specialized. The baking process is
specialized. GM will want to not let the info leak. GM will want to monitor those workers
more.
7. Specify the differences between the stockholder model and the stakeholder model.
Which would you use, and why, to resolve the Poletown Case discussed by
Goodpaster? (10)
Answer: See handouts from Rongione
8. Suppose a worker has the following utility function (15)
U = I - e3
where I is annual income and e is work effort.
The worker has a reservation utility level of 1000. If the worker’s utility is below 1000,
he will not work at all.
a) Knowing this, the employer’s cost as a function of worker effort is?
Answer:1000 +e3
Now suppose the revenue to the firm as a function of the worker’s effort is:
B = 1200e
b) The profit maximizing level of work effort is?
Answer: Profit = 1200e – 1000 - e3
DProf/de = 1200 – 3e2 = 0 or e = 20.
c) The worker’s annual income is?
Answer: 9000
d) The firm’s maximum profit is?
Answer: 24000-9000=15000
e) If the worker is not monitored at all, his work effort will most likely be?
Answer: 0 or he will be smart enough to satisfice (0<e<20) to keep his job
f) In plain English, define the principal-agent problem. List two ways in which
principals attempt to resolve the problem.
Answer: The principal hires an agent to act on his/her behalf. The problem is that the
agent acts in his own self interest. Monitoring and incentive compensation can resolve the
problem.
g) List two reasons why franchising might not be a viable solution to the principal-agent
problem.
Answer: Wealth constraint, team production, risk aversion