Michael Ahern
Firms and Markets
Problem Set 5
1) The Giant Corporation
Do not Expand $2MM, $30MM
Response:
Aggressive: -$2MM, $10MM
Passive: $4MM, $20MM
Giant, Inc’s response to an expansion will be passive because $20MM is greater than
the $10MM received in an aggressive response. The Small Corp should expand.
Small
Corp
Do Not Expand
Expand
2MM,
30MM
Giant
Corp
4MM,
20MM
2MM,
10MM
2) Market for Lemons
Probability(L) = 0.33
Probabilitiy(Q) = 0.67
Buyers Price = $2,500
Reservation Price = Probability(L) x $0 + Probability(Q) x Buyers Price
= 0.33 x 0 + 0.67x $2,500 = $1,675
Seller’s Price = $2,000
1,675 < 2,000 so the equilibrium is no sales take place.
3) Natives and tourists
Consumer
Strategy
Don’t Buy
Buy
Low-Quality
0,0
-10,10
Firm
High Quality
0,-10
1,1
a) There are no dominant strategies. The Nash Equilibrium is Buy/High Quality.
The firm would prefer to sell low quality (10).
b) If the customer is a repeat customer and/or the purchasing customer has
access to other customers. A local merchant in a small town would have these
concerns as the town residents communicate with each other and the town
residences are the mainstay of his business. In an Internet economy the
entire world has the potential to be a “small town” and posted
recommendations from other consumers are the most trusted source among
available purchasing influences sources. In this situation the merchant is
motivated to provide a quality product and service.
c) Locals in a restaurant and much more likely to be repeat customers. Tourists
on the other hand have a much higher probability of being both single
transaction customers and a much lower probability of communicating a
poor quality experience to potential future customers.
4) Restaurant Hygiene
a) A restaurant owner can save labor expense by not maintaining a clean
kitchen and restaurant. Customers generally do not see the kitchen.
However, if the kitchen is persistently dirty and lacks hygiene the probability
of customers getting sick from the food served increases.
b) Some supermarket chains have been found guilty of repacking and re-dating
food that was older than the legal sell by date. This is sometimes exposed by
a whistle-blower employee. Though the store usually gets away with this
practice as food generally lasts longer than the sell by date. However, some
small percentage of customers will likely get food poisoning as a price for the
store’s increased profits.
Ford Motor Company had a famous example related to the Pinto and it’s fuel
tanks which had a tendency to explode and kill the passengers upon impact.
Ford decided it was cheaper to let the people die and deal with the litigation
than to recall the cars and fix the problem. This is an extreme example in
which some people died so that Ford could save money and was considered
highly unethical.
c) The median grade hygiene score rose from 75% to 85%, and then 90% with
the introduction of each new objective measure.
d) I believe there are two possibilities. First the restaurant inspectors may have
been using the subjective grade to elicit bribes from the restaurant managers.
The inspectors were incentivized to keep the grades low and the bribes high.
Second removing the subjective component of the grades made the system
more fair and took power away from the inspectors. The new grades more
closely resembled the true grades.
e) The grade card system gave incentive for the restaurants to have cleaner
kitchens. Once the objective condition of restaurant kitchens became public
the customer had a much better decision point. Restaurants that received
grades of C or lower were likely to experience a serious decline in sales. Even
a B could impact some sales. In the United States the expectation is for a
clean kitchen and anything short of that will impact sales.
f) The grade cards provided a partial solution to the asymmetric information
problem. Restaurants are not graded on a continuous or even daily basis; if
grading was continuous the problem would be solved. Given the existing
system of periodic inspections, restaurants could find a way to “game” the
system and only have their kitchens clean on the days they are inspected.
Barring significant gaming of the system the restaurants appear to have
improved particularly once the grades became published in the windows. We
should also factor in that before the subjectivity of the restaurant report was
removed inspectors likely had an incentive to push the grades down.
A probable economic effect of the initial asymmetric information problem
was that people may have chosen to eat at home more often in kitchens they
themselves cleaned or to chose from among a regular staple of restaurants
with good reputations. The grade cards help newer restaurants that have not
developed reputations by encouraging new customers. New customers can
try out an “A” graded restaurant for the first time with a greater sense of
confidence that they are being served from a clean kitchen.
Though we don’t have any data on restaurant sales it is clear from the chart
that the overall cleanliness of Los Angeles restaurants improved
substantially in the one year period from July, 1997 to July, 1998.