Economics

BEHAVIORAL ECONOMICS A management consultant advised a small business owner to fully analyze all transaction costs, delineate the boundaries of the business, and develop an equation to calculate exactly economies of scope. The owner replied that there were not enough hours in the day to gather all this information and so the owner would just keep running the business in the same way as usual. What assumption from traditional economics is in dispute here?

SIGNALING AND SCREENING What roles do signaling and screening play in a labor market with asymmetric information?

Boundaries of the Firm In the movement to downsize government, advocates often recommend turning over some government services to private firms hired by the government. What are the potential benefits and costs of such outsourcing? Prepare your answer by reviewing. The Outsourcing Institute's "Top 10 Reasons Companies Outsource" at http://www.horizontech.net/toptenreasons.htm.

Login to www.cengagebrain.com and access the Global Economic Watch to do this exercise. Global Economic Watch Go to the Global Economic Crisis Resource Center. Select Global Issues in Context. In the Basic Search box at the top of the page, enter the phrase "behavioral economics." On the Results page, go to the Global Viewpoints Section. Click on the link for the July 15, 2010, editorial "Economics Behaving Badly." The authors stated, "Behavioral economics should complement, not substitute for, more substantive economic interventions." Use one of the examples from the editorial to explain this statement.

SIGNALING Give an example of signaling in each of the following situations: a. Choosing a doctor b. Applying to graduate school c. Filling out a form for an online dating service

ECONOMIES OF SCOPE Distinguish between economies of scale and economies of scope. Why do some firms produce multiple product lines, while others produce only one?

SEARCH WITH IMPERFECT INFORMATION The following questions concern the accompanying graph. a. Identify the two curves shown on the graph, and explain their upward or downward slopes. b. Why does curve A intersect the horizontal axis? c. What is the significance of quantity d ? d. What does e represent? e. How would the optimal quantity of information change if the marginal benefit of information increased-that is, if the marginal benefit curve shifted upward?

Case Study: The Reputation of a Big Mac Explain how the time and financial requirements involved in obtaining a McDonald's franchise relate to the hidden-characteristics problem. Why would existing franchise owners have an interest in the maintenance of high application standards for new franchise owners? Reference Case Study: World of Business Reputation of a Big Mac McDonald's has 32,000 restaurants in more than 120 countries and employs more than a million people. The secret to their success is that customers around the world can count on product consistency whether in Phoenix, Anchorage, Moscow, or Hong Kong. McDonald's has grown because it has attracted competent and reliable franchise owners and has provided them with appropriate incentives and constraints to offer a product of consistent quality. To avoid adverse selection, McDonald's seldom advertises for franchisees yet still has plenty of applicants. Even to be granted an interview, an applicant must show substantial financial resources and good business experience. An applicant who passes the initial screening must come up with a security deposit and complete the nine-month full-time training program. A franchise costs anywhere from $950,000 to $1,800,000, depending on the size and location, plus an opening fee of $45,000. Of that amount, the new franchisee must have "non-borrowed personal resources," of at least $500,000 in cash; this money can't come from friends or relatives. In effect, the applicant must have saved this amount or own assets such as property or stock that could be sold to raise the cash. Those with more savings have an edge in the selection process. McDonald's uses personal wealth as a signal of the individual's business sense and ability to manage money. The rest can be borrowed from a bank but must be paid back in no more than seven years. McDonald's is using the bank's loan officers to screen the applicant's creditworthiness. During the training period, the applicant is paid nothing, not even expenses. Some who complete training are rejected for a franchise. Once the restaurant opens, a franchisee must work full time. McDonald's does not offer franchises to partnerships or to groups of investors. Thus, the franchisee has a deep financial stake in the success of the operation. As a further incentive, successful owners may get additional restaurants. If all goes well, the franchise is valid for 20 years and renewable after that, but it can be canceled at any time if the restaurant fails the company's standards of quality, pricing, cleanliness, hours of operation, and so on. The franchisee is bound to the company by highly specific investments of money and human capital, such as the time invested learning McDonald's operating system. The loss of a franchise would represent a huge financial blow. Through its franchise policies, McDonald's is trying to protect its most valuable asset-its reputation for "quality, service, cleanliness, and value." The golden arches are the second most recognized corporate symbol in the world (the stylized lettering of Coca-Cola ranks first). In selecting and monitoring franchisees, McDonald's has successfully addressed problems stemming from hidden characteristics and hidden actions.

BOUNDARIES OF THE FIRM Ashland Oil buys its crude oil in the market. Larger oil refiners, such as Texaco, drill for their own crude oil. Why do some oil companies drill for their own crude oil and others buy crude oil in the market?

ASYMMETRIC INFORMATION Define asymmetric information. Distinguish between hidden characteristics and hidden actions. Which type of asymmetric information contributes to the principal-agent problem?

ADVERSE SELECTION AND MORAL HAZARD Describe the problems faced by health insurance companies as a result of adverse selection and moral hazard. How do insurance companies try to reduce these problems?

SEARCH WITH IMPERFECT INFORMATION Determine the effect of each of the following on the optimal level of search. a. The consumer's wage increases. b. One seller guarantees to offer the lowest price on the market. c. The technology of gathering and transmitting market information improves.

Login to www.cengagebrain.com and access the Global Economic Watch to do this exercise. Global Economic Watch Go to the Global Economic Crisis Resource Center. Select Global Issues in Context. In the Basic Search box at the top of the page, enter the term "moral hazard." Choose an article published in the most recent two years. Explain how the article illustrates the concept of moral hazard.

SEARCH WITH IMPERFECT INFORMATION Fifty years ago, people shopped by mail using catalogs from large mail-order houses. In the last few years, catalog shopping has again become a widely used method of buying. Online shopping is also growing. What reasons can you suggest for the growth in these forms of shopping?

BOUNDARIES OF THE FIRM Define vertical integration. What factors should a firm consider when determining what degree of vertical integration to undertake?

RATIONALE FOR THE FIRM Explain Ronald Coase's theory of why firms exist. Why isn't all production consolidated in one huge firm?

THE PRINCIPAL-AGENT PROBLEM Discuss the nature of the principal-agent problem. Determine which is the principal and which is the agent in each of the following relationships: a. A firm that produces goods for export and the export management company that helps market its goods overseas b. The management of a firm and its stockholders c. A homeowner and the plumber hired to make repairs d. A dentist and a patient e. An employee-pension management firm and the company using its services