Answer Section
,
,Chapter 2 The Firm and Costs
1. If managers’ income were entirely independent of their firm’s performance, they would have little
incentive to work hard at raising the firm’s profits above some bare minimum that shareholders
would accept. They would have little incentive either to limit their own perquisites.
2. If an oil spill occurs, the limited liability of a corporation will limit the amount of damage payments
to the amount generated from selling all the assets of the corporation. A sole proprietor could be held
personally responsible for the total damage. This liability may also encourage a sole proprietor to take
more safety precautions than a corporation.
3. Vertical mergers are more likely in such countries. Because firms have less protection against
opportunistic behavior by firms they might contract with—customers or suppliers—they are more
likely to preclude such behavior by merging with those firms.
4. One would expect the more remote outlets to be owned by franchisees, because they are more
expensive to monitor by the central office.
5. Once the contract has been signed, the reputation of the franchise is, in a sense, “hostage” to good
behavior by the new franchisee. A franchisee could at some point threaten to damage that reputation
(for instance by providing low-quality service) unless the franchiser agrees to reduce the franchise
fee. The neon sign helps prevent such opportunistic behavior, because it is an asset that is highly
specific to the franchise: it would become useless to the franchisee if the franchiser ever canceled the
contract. In a sense, the contract therefore represents an exchange of hostages; providing both parties
with a means of damaging the other party makes it less likely that either will do so.
6. Arguably, market economies are more efficient because they have a better mix of central control and
market exchange. Introducing market exchange to the factory floor would be very inefficient because
it would result in huge transaction costs.
7. If a firm is highly leveraged, it has a large amount of debt relative to equity. Since debt is a liability,
all other things equal, it is riskier to hold highly leveraged shares. Shareholders of highly leveraged
firms are less likely to receive returns on their investment, especially if debt holders are paid before
equity holders. Shareholders expect higher returns from highly leveraged firms to compensate for the
higher level of risk.
8. Debt holders would be prepared to give up any amount of S for even the smallest increase in F,
because their expected return is independent of the former but increases with the latter. The opposite
holds for equity owners.
, 82 Carlton/Perloff • Modern Industrial Organization, Fourth Edition
9. The expected return to bondholders is
pα (1 + r ) + (1 − p)F − α
rB = ,
α
whereas that to equity owners is
p[S − α (1 + r )] − (1 − α )
rE = .
1−α
Differentiating both with respect to α yields
∂rB −(1 − p)F
= < 0,
∂α α2
∂rE p[S − (1 + r )]
= > 0.
∂α (1 − α )2
Individual bondholders have a lower expected return the more highly leveraged the firm becomes,
because if the project is successful their return per dollar invested remains the same, whereas in the
event of bankruptcy the assets FL of the firm have to be shared among a larger number of them. Their
return per dollar invested is in the latter case equal to F/α, which falls with α.
Equity owners, on the other hand, have a higher expected return, because, in the event of bankruptcy,
their share of the firm’s assets remains the same (zero), whereas if the project is successful their
return per dollar invested increases. The latter return is
S − α (1 + r )
rE in case of success = ,
(1 − α )
which increases with α, because
∂rE in case of success S − (1 + r )
= > 0.
∂α (1 − α )2
(Firms would never invest in a project for which S < 1 + r.)
For both bondholders and equity holders the return per dollar invested becomes riskier.
10. Economies of scope may exist. It may be cheaper for one firm to make both chocolate bars and
caramels than for two firms to specialize in each good.
11. (i) If Firm G canceled the contract and fired its workers, it would receive the equivalent of $150 per
year (10% interest on $1,500) from scrapping the furnace, leaving it with a loss of $800 − $150
= $650 per year. Firm H could therefore threaten to cut the fee to just above $350 per year,
because that would impose a smaller loss on Firm G.
(ii) Accepting Firm J’s offer would involve a loss of $800 + $300 − $700 = $400 per year, so that
Firm H could in this case only threaten to cut the fee to just above $600 per year.
12. The manufacturer should still go ahead with its original plans, because the $200,000 dollars already
paid to the engineering firm are a sunk cost: this fee should not affect any future decisions.
13. Buying a machine that no one will want to purchase or rent is a sunk cost, while renting the machine
is an avoidable cost. If the firm goes out of business, it can stop paying the machine rental.
,
,Chapter 2 The Firm and Costs
1. If managers’ income were entirely independent of their firm’s performance, they would have little
incentive to work hard at raising the firm’s profits above some bare minimum that shareholders
would accept. They would have little incentive either to limit their own perquisites.
2. If an oil spill occurs, the limited liability of a corporation will limit the amount of damage payments
to the amount generated from selling all the assets of the corporation. A sole proprietor could be held
personally responsible for the total damage. This liability may also encourage a sole proprietor to take
more safety precautions than a corporation.
3. Vertical mergers are more likely in such countries. Because firms have less protection against
opportunistic behavior by firms they might contract with—customers or suppliers—they are more
likely to preclude such behavior by merging with those firms.
4. One would expect the more remote outlets to be owned by franchisees, because they are more
expensive to monitor by the central office.
5. Once the contract has been signed, the reputation of the franchise is, in a sense, “hostage” to good
behavior by the new franchisee. A franchisee could at some point threaten to damage that reputation
(for instance by providing low-quality service) unless the franchiser agrees to reduce the franchise
fee. The neon sign helps prevent such opportunistic behavior, because it is an asset that is highly
specific to the franchise: it would become useless to the franchisee if the franchiser ever canceled the
contract. In a sense, the contract therefore represents an exchange of hostages; providing both parties
with a means of damaging the other party makes it less likely that either will do so.
6. Arguably, market economies are more efficient because they have a better mix of central control and
market exchange. Introducing market exchange to the factory floor would be very inefficient because
it would result in huge transaction costs.
7. If a firm is highly leveraged, it has a large amount of debt relative to equity. Since debt is a liability,
all other things equal, it is riskier to hold highly leveraged shares. Shareholders of highly leveraged
firms are less likely to receive returns on their investment, especially if debt holders are paid before
equity holders. Shareholders expect higher returns from highly leveraged firms to compensate for the
higher level of risk.
8. Debt holders would be prepared to give up any amount of S for even the smallest increase in F,
because their expected return is independent of the former but increases with the latter. The opposite
holds for equity owners.
, 82 Carlton/Perloff • Modern Industrial Organization, Fourth Edition
9. The expected return to bondholders is
pα (1 + r ) + (1 − p)F − α
rB = ,
α
whereas that to equity owners is
p[S − α (1 + r )] − (1 − α )
rE = .
1−α
Differentiating both with respect to α yields
∂rB −(1 − p)F
= < 0,
∂α α2
∂rE p[S − (1 + r )]
= > 0.
∂α (1 − α )2
Individual bondholders have a lower expected return the more highly leveraged the firm becomes,
because if the project is successful their return per dollar invested remains the same, whereas in the
event of bankruptcy the assets FL of the firm have to be shared among a larger number of them. Their
return per dollar invested is in the latter case equal to F/α, which falls with α.
Equity owners, on the other hand, have a higher expected return, because, in the event of bankruptcy,
their share of the firm’s assets remains the same (zero), whereas if the project is successful their
return per dollar invested increases. The latter return is
S − α (1 + r )
rE in case of success = ,
(1 − α )
which increases with α, because
∂rE in case of success S − (1 + r )
= > 0.
∂α (1 − α )2
(Firms would never invest in a project for which S < 1 + r.)
For both bondholders and equity holders the return per dollar invested becomes riskier.
10. Economies of scope may exist. It may be cheaper for one firm to make both chocolate bars and
caramels than for two firms to specialize in each good.
11. (i) If Firm G canceled the contract and fired its workers, it would receive the equivalent of $150 per
year (10% interest on $1,500) from scrapping the furnace, leaving it with a loss of $800 − $150
= $650 per year. Firm H could therefore threaten to cut the fee to just above $350 per year,
because that would impose a smaller loss on Firm G.
(ii) Accepting Firm J’s offer would involve a loss of $800 + $300 − $700 = $400 per year, so that
Firm H could in this case only threaten to cut the fee to just above $600 per year.
12. The manufacturer should still go ahead with its original plans, because the $200,000 dollars already
paid to the engineering firm are a sunk cost: this fee should not affect any future decisions.
13. Buying a machine that no one will want to purchase or rent is a sunk cost, while renting the machine
is an avoidable cost. If the firm goes out of business, it can stop paying the machine rental.
