# BPP Field Exam 2006

The 2006 field exam was on June 23rd 2006. Reference material was permitted, communication was not. It was stated that grading would be based on the assigned times for each question.

## Format and Originators

The 2006 BPP field exam had the following format:

• Morning (3 hrs): Question A.1 or A.2 (2hr), Question B.1 or B.2 (1hrs)
• Afternoon (3 hrs): Question C.1 or C.2 (1hr), Question D (2hrs)

The best guess as to question originators is:

• A.1 - de Figueiredo
• B.1 - Mowery
• B.2 - Dal Bo
• C.1 - Teece (written by Chesbrough)
• C.2 - Morgan
• D - Spiller

## Questions

### A.1: The Theory of Partnerships

A partnership group has a surplus it needs to allocate to the partners at the end of the year. The procedure it uses (as enshrined in its Operating Agreement) is as follows. Decisions are made by a committee-of-the whole (i.e. the entire partnership). At the annual meeting for the partnership, one of the partners is chosen randomly (with each having an equal likelihood of being selected) to propose an allocation to each of the members, including herself. If her proposal is accepted by a majority of the partnership, then that proposal is implemented. If it is not passed by a majority, then another partner is chosen randomly to make a proposal and the procedure repeats. All of the partners prefer higher allocations to lower allocations, and faster decisions to slower decisions.

a.) Outline a model of the above situation. Assuming the game is a single-shot and there are no punishments by the partnership (no reputation effects), discuss the equilibrium for your model. Note: you do not have to solve the model; simply discuss the proposition(s) you expect that could be derived and the intuition(s) behind it (them).

b.) Suppose that the partnership (membership) is stable, infinitely-lived, and makes a surplus allocation decision every year. How would you account for this in your model? Discuss equilibrium behavior and strategies using these assumptions (again you do not need to explicitly solve the model, simply explain your reasoning).

c.) Returning to the one-shot/no-reputation case, consider what would happen if partnership shares are not distributed evenly, and members have probabilities of being recognized which are proportional to their shares. What would be the equilibrium strategies and outcomes you would expect in this case?

d.) Finally, consider what would happen if both voting rights and recognition probabilities were proportional to the shares held, what would you expect in this case?

### A.2: Managerial Productivity & Incentives

Consider Holmstrom's 1982 managerial model, except that the manager knows her productivity parameter from the start. The manager lives for two periods $(t = 1, 2)\,$. Once she is employed by a firm in period $t\,$, the firm's production cost is $C_t = \Beta - e_t\,$, where $\Beta\,$ is the her productivity parameter and $e_t \gt 0\,$ is the effort she exerts at a cost of $\phi(e_t)\,$ (with $\phi' \gt 0\,$ and $\phi'' \gt O\,$). $C_t\,$ is observable but not verifiable, but $\Beta\,$ and $e_t\,$ are not observed by the firms. The manager's utility is $\sum_{t=1}^2 \delta^{t-1}[I_t -\phi(e_t)]\,$, where $I_t\,$ is her income at time $t\,$ and $\delta\,$ is her discount factor. Firms are competitive (they derive the same benefit from the manager's activity) and the manager cannot commit to staying with the same firm. It is common knowledge that $\Beta \in \{\underline{\Beta}, \overline{\Beta}\}\,$, where $\overline{\Beta} \gt \underline{\Beta} \gt 0\,$, and $Pr(\Beta = \overline{\Beta})=p\,$. Let $\Delta\Beta \equiv \overline{\Beta} - \underline{\Beta}\,$, and assume that $\phi(\Delta\Beta) \lt \delta\Delta\Beta\,$.

a.) Derive the best separating equilibrium for the manager (the manager offers the contract). In your answer, comment on the "intuitive criterion".

Depart now from part (a) above by assuming that the cost is verifiable, and that there is only one firm which chooses incentive schemes in both periods. Assume further that the firm cannot commit to a second period incentive scheme in the first period.

b.) Show that if the firm wants to separate the two types, then in the first period it must offer cost targets $\underline{C}\,$ and $\overline{C}\,$ such that $(\underline{C} - \overline{C})\,$ does not converge to zero as $\Delta\Beta\,$ goes to zero. (Using a quadratic $\phi(\cdot)\,$ may simplify the derivations. Hint: look at manager $\underline{B}\,$'s second period rent when she pretends to be $\overline{B}\,$. Write the two intertemporal incentive constraints).

c.) Use an intuitive argument to conclude that the optimal scheme for the firm is to have the two types pool when $\Delta\Beta\,$ is small.

### B.1: Understanding Innovation

a.) Explore the role of complementarities in the innovation process. To what extent has the modern literature augmented our understanding on this issue as compared to Schumpeter.

b.) To what extent are new frameworks needed to explain commercial successes and failures in the innovative process.

### B.2: The Alleged Inefficiencies of Democracy

Discuss the following paragraph:

The democratic system as we know it is bound to be inefficient. Multiple factions will get organized in order to compete for the spoils of government, in what will effectively be a legitimized rent-seeking contest that will dissipate enormous amounts of wealth. It would be far more efficient to either

a.) Have a dictatorship, or

b.) To auction off the presidency every 4 years. In this way, instead of spending effort, competing parties would bid a money transfer to the state which only has to [be] paid by the winner, and which could be returned to citizens.

### C.1: Open Innovation

Professor Henry Chesbrough of the Haas School of Business (a BPP PhD) recently coined the term, "open innovation," which he describes as a new model for managing corporate innovation in which "firms can and should use external ideas as well as internal ideas, and internal and external paths to market, as the firms look to advance their technology."

a.) Discuss the use of "open innovation" by the firms and entrepreneurs discussed by Lamoreaux and Sokoloff and the Joseph Schumpeter of The Theory of Economic Development?

b.) What factors underpin the (asserted) revival of the "open innovation" strategy?

c.) What are the characteristics of knowledge that support or undercut the effectiveness of the "open innovation" strategy?

d.) What type of intellectual property "regime" favors the development of an open innovation strategy for the firm seeking to tap the supply of "external ideas" environment?

e.) Under what circumstances can prospective entrants benefit from the open innovation strategies of incumbent firms?

### C.2: The Organizational Implications of the Modigliani-Miller Theorem

The Modigliani-Miller theorem provides conditions where a firm's capital structure is irrelevant to its investment decisions. Yet, in practice, a firm's capital structure does seem to profoundly affect investment decision making as well as the valuation placed on the company in capital markets. Using tools and concepts from the field of contract theory, offer some explanations for the following questions.

a.) What determines the optimal stake in a company for outside equity to take in an owner-operated firm? How does the structure of the stake (debt versus equity) affect this decision?

b.) What determines when a firm should make a seasoned equity offering (i.e. sell additional equity in the capital market after previously issuing equity at some point in the past)? How should markets respond to seasoned equity offerings in determining the valuation of a firm?

c.) A firm is competing with several other firms in trying to acquire some other company that is on the market. What determines the optimal bidding strategy? How should the market respond to a successful acquisition in terms of the share price for the acquirer and the target?

d.) Suppose that a firm is selling some assets and faces bidders offering equity stakes. When would it prefer to sell for equity versus selling in exchange for cash or debt?

In formulating your answers, please describe one or more of the key economic tradeoffs associated with each of the questions and describe how these tradeoffs are affected by some of the details of the situation. In particular, your answers should focus on how the organization will react to changes in its balance sheet in terms of effort undertaken in the organization, projects pursued or not pursued, and acquisitions pursued or not pursued.

In doing so, you may, at your discretion, provide a "toy model" to illustrate your answer. You may also, at your discretion, highlight key existing work illuminating the tradeoffs you have identified.

### D: Public Sector Reform in New Zealand

Labor relations in the New Zealand public service sector have been changed significantly since the State Sector Act (1988). For example, the wage-fixing system in the public service before 1988 was based on a centrally negotiated "annual general adjustment" to pay rates, and a system of service-wide pay rates and scales applied to some 200 employee occupational classifications.

The 1988 Act made chief executives the employer, and set out requirements in terms of the merit principle and other "good employer" provisions. The State Services Commission, the public employer, delegated collective bargaining authority to chief executives, replacing the previous system of centrally determined pay and conditions. Chief executives are accorded "all the rights, duties, and powers of an employer" with respect to the employees of their departments. Thus, chief executives may appoint "such employees [as they] think necessary for the efficient [operation of their department]"; and, subject to agreed conditions of employment, they may also remove employees "at any time".

Chief executives, in consultation with the State Services Commission, make also appointments to Senior Executive Service positions on the basis of merit, for terms not exceeding five years (with eligibility for reappointment), and set conditions of service. In turn, Chief executive appointments are approved by Cabinet, based on the Commission's recommendation. The Cabinet may decline the recommendation, in which case it may direct the Commission to appoint a named person to the position. Chief executives are the equivalent of deputy heads of departments, one level below that of a secretary of a ministry in the US.

Occupational classes were rationalized: for example, the Ministry of External Relations and Trade has reduced the number of classifications from 16 to two, and in 1993 the Ministry of Agriculture and Fisheries had only four. The location of an individual in a salary range is dependent on performance, and chief executives and managers have discretion in where they place individuals within the range. Departments may also pay bonuses to staff if they wish.

Discuss:

a.) Develop a theoretical framework to analyze from a positive perspective the introduction of bureaucratic restrains on chief public officials

b.) Using this framework analyze the implications of New Zealand's reforms removing such bureaucratic restrains

c.) Discuss the institutional conditions that impact the effectiveness of these reforms

d.) Develop an empirical way by which you could test your analysis in (a) through (c).