University of California ECON 153 Assignment #5 Winter 2015

Multiple Choice:

[2 points each question]

1. Transaction cost is:

(a) the cost of buying and selling goods and services.

(b) the cost of negotiating, enforcing, and administering contracts.

(c) the cost of negotiating agreements between labor and management.

(d) the cost of making transactions.

2. Moral hazard is:

(a) the risk one party will opportunistically exploit for self-advantage holes or gaps in an

incomplete contract.

(b) the risk that one party will not be truthful in negotiating a contract.

(c) the negotiating cost employers and employees suffer in writing and enforcing

incomplete contracts.

(d) the possibility that employees will commit unethical acts, such as lying and stealing.

3. A more serious problem with input-based pay systems (e.g., a wage per hour), relative to

an output-based system, is:

(a) the difficulty of measuring the worker’s output.

(b) the cost of administering the pay system.

(c) workers will maximize output and neglect quality.

(d) workers have an incentive to shirk.

4. According to tournament theory:

(a) pay gaps between job positions get larger at successively higher levels in the

organizational hierarchy.

(b) high executive pay is due to moral hazard.

(c) people seeking the CEO’s job compete to acquire the right signal about their

productivity.

(d) employee teams perform better when workers get paid based on their team’s

performance.2

Problems: Answer the following questions. In order to receive full marks, all intermediate

work leading to the final answer must be shown.

5. An investment bank is planning to interview 10 job candidates, randomly chosen from

the applicant pool. Individuals differ in their abilities to put together deals and perform

other functions that are part of an investment banker’s job. Past experience has shown that

individuals can be categorized into productivity levels given by the following table:

Type A B C D E

Proportion of Applicant Pool 0.1 0.2 0.3 0.3 0.1

Average Output (in $000s) -100 0 50 100 200

A worker can be hired for $40,000 per year.

(a) [3 points] If the firm hires all 10 of the job candidates, what would be its expected

profit (assuming the firm only incurs labor costs)?

(b) [3 points] Suppose the firm can put workers through a series of tests before hiring

them. The set of exams costs $1,000 per worker to administer, but gives definitive

information on whether the worker is Type A or B before being hired. If the firm

interviews 10 job candidates, how many is it expected to hire with the screening in place?

What is the expected profit with the screening approach? Will the firm pay for screening to

avoid hiring Type A and B workers?