# BPP Field Exam 2007

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The 2007 field exam was on June 26th 2007. 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 2007 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 - Tadelis
• A.2 - Dal Bo
• B.1 - Teece
• B.2 - de Figueiredo
• C.1 - Mowery
• C.2 - Morgan
• D - Spiller

## Questions

### A.1: 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 $e_t \ge 0\,$ 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.

### A.2: Lobbying and policy choice

Consider a society where a policy maker will select policy $x \in [0,1]\,$. There are two interest groups. Group 1 and Group 2. Both groups are willing to pay a fixed cost $f_i \ge 0, i=1,2\,$ in order to set up lobbying capabilities, i.e., to "organize." A group that has organized is in a position to make contributions $c_i\,$ to the policymaker in order to attempt to sway the decision of the latter. A group that is not organized cannot make contributions and hence cannot influence policy.

The policymaker cares both about policy and money. Her preferences are as follows:

$U(x)+ c_1 - c_2 = -x^2 + x + c_1 + c_2\,$

while those of the interest groups are,

$V_i(x) - f_i - c_i\,$

with $V_1 = - x^2 + 1\,$, and $V_2 = -x^2 + 2x\,$. Note the fixed costs are a waste in that the policymaker does not benefit from them (nor does anyone else).

The timing of interaction in this society is as follows. 1) Both interest groups decide, simultaneously and noncooperatively, whether to organize. 2) The organization decisions become known to everyone, and whomever is organized makes contributions $c(x)\,$ to the policymaker in the form of a schedule of contributions contingent on the policy that is finally chosen. If both groups are organized, contributions are made simultaneously and noncooperatively, and you should assume that a Truthful Nash equilibrium is played. 3) Knowing the contributions offered, the policymaker selects policy. All payoff functions and the structure of the interaction are common knowledge.

a.) Solve for the policy that the policymaker would select when no group gets organized.

b.) Solve for the policy that each interest group will induce when being the only group that is organized.

c.) Suppose that $f_i=\epsilon, 1=1,2\,$, where $\epsilon\,$ is a number strictly greater than zero but arbitrarily close to it. What is the subgame perfect equilibrium of the game in terms of organization decisions and implemented policy? Comment on the efficiency properties of this equilibrium, especially in relation to the efficiency properties of the equilibrium in Grossman and Helpman (1994).

d.) You are asked to participate in a debate on the ways to curb business influence on policy. The government can use one of two anticorruption measures, given its technical and enforcement capabilities. One thing the government can effectively do is stop one interest group from organizing altogether. Or it can make organization very tedious for both groups, raising the wasteful organization costs $f\,$ for both groups. There is no limit to the government's ability to raise the fixed costs of organization. You are asked to select the anticorruption policy that would be more appropriate to eliminate inefficiency and waste. Briefly explain which measure would you favor and why.

e.) How would you use this model to study the causes and consequences of lobbying in relation to the pharma industry? What limitations would you find in applying this model?

### B.1: Theory of the Firm

How might a Schumpeterian theory of the firm differ from a Coasian one? Are the frameworks competitive or complementary, and why?

### B.2: Industry self-regulation

Mechanisms by which an industry sets its own standards for operation and conduct and "self-police" is a common phenomenon. Despite its extensiveness, such self-regulation is relatively poorly understood. What incentives do these mechanisms provide? Under what conditions are the institutions of self-regulation self-enforcing? Is self-regulation a substitute or complement to government regulation (or under what conditions would each hold)?

Outline a model which would shed light on self-regulation, including answers to the above questions. You should be specific about the model structure (e.g. players, preferences, game form, information, and so on) and justify why the model is an appropriate one for studying self-regulation. In addition, discuss what you believe the equilibrium to the model would be. Finally, discuss the predictions and insights which would be generated from your model. Note: you do not need to solve the model; simply discuss the proposition(s) you expect that could be derived and the intuition(s) behind it (them).

### C.1: Patent Policy & Firm Strategy

On April 30, 2007, the US Supreme Court issued a decision that has been widely interpreted as raising the level of "nonobviousness" required to obtain a patent, thereby making patents "harder to obtain and defend," according to the New York Times (5/1/07).

a.) Discuss the effects of this decision on the level of patenting and the quality of patenting by incumbent firms in the information technology and pharmaceuticals industries.

b.) What are the likely effects of this change in patent policy in entry into the information technology and pharmaceuticals industries? How will the long-term evolution of industry structure be affected?

c.) Discuss the effects of this policy change on on patenting & licensing by U.S. universities.

d.) Will "innovation suffer" as a result of this decision, per the claims of industry groups representing pharma & biotech firms? Why/why not?

e.) A National Academy of Sciences panel has been organized in 2015 to evaluate US patent policy, in recognition that the effects of the Supreme Court decision took years to reveal themselves and in recognition of the fact that no other revisions in patent policy occurred during 2007 - 2015. You are asked to evaluate the effects of the 2007 Supreme Court decision. Develop a research design to test your hypotheses concerning the decision's effects on the information technology and pharmaceuticals industries.

Another potentially important development in US patent policy (which you can ignore in answering part (e) above) is a Congressional proposal that would (among other things) introduce a "post-grant opposition" procedure, enabling interested parties to contest the validity of issued patents within 9 months of issue in an administrative procedure. The opposition procedure would not affect the right of parties to an opposition to pursue claims concerning validity or infringement of patents in the federal courts.

f.) Assuming that a post-grant opposition procedure of this type is introduced, how would its presence influence your answers to questions (a)-(d)?

### C.2: Contracting with and without commitment

An upstream party produces an input that is essential to a downstream party's production process. The more of this input the downstream party receives, the greater its surplus (ignoring the price agreed to for the transfer of the input) but subject to diminishing returns. The upstream party can produce this input at a constant cost per unit. While upstream knows its costs, downstream is uncertain whether upstream's cost per unit is high or low. It thinks that high and low costs are equally likely.

The relationship between the two parties will last two periods and each shares a common discount factor. Moreover, the costs to produce the input do not change from one period to the next.

a.) Consider a long-term contract proposed by downstream party that specifies a transfer amount in each period as a function of the quantity of inputs provided by the upstream party in that same period. Set up and derive the optimal contract under this setting. What is the key tradeoff driving the structure of the contract?

b.) Consider an alternative contract. In this contract, downstream party writes a contract that determines the quantity of the input to be supplied and the transfer to be made in both periods solely as a function of the reported cost of the upstream party. Set up and derive the optimal contract under this setting. Which is the more effective contract for the downstream firm-that described in part (a) or that described in part (b)?

c.) Now suppose that the downstream firm cannot enter into long term contracts. Instead, it enters into a series of one period contracts stipulating the quantity of the input and the transfer price as a function of the reported cost. Explain how an optimal contract works in this setting. Specifically, demonstrate that the firm can or cannot earn the same expected profits as in part (b).

d.) Consider a third alternative. Suppose that, prior to learning its costs, downstream can propose to buy the upstream firm via a take it or leave it offer. If the offer is rejected, the two firms rely on spot market contracts (as in part (c)) in each period. How much does the downstream firm have to offer upstream firm to get it to sell out? Is this vertical integration a profitable strategy?

e.) Consider again the vertical integration decision, but assume that the firm can engage in long-term contracting as in part (b). How does this change the optimal take it or leave it offer? Is vertical integration profitable?

### D: Airport Privatization

The year is 2007 and Governor Schwarzenegger has launched an initiative to improve the performance of California's airport system. For that purpose a Commission within the Governor's office has been formed to move the operation and future development of California's airports into private hands. The apparently successful UK experience with airport privatization is what the Governor wants to emulate. You have been named to the Commission because of your training in economics, transaction costs economics, positive political theory and organization theory. Your role is to contribute to avoid implementing an airport privatization scheme that may generated substantially negative "unexpected consequences" in the future.

1.) What are the prospective benefits of bringing incentives into the public sector in general, and what are the possible costs?

2.) Focusing specifically on California's airport system privatization, indicate:

a.) How each of the four literatures referred to above informs the project;

b.) To what extent these four literatures interact, and in what way a synthetic approach can provide answers different than each individual literature on its own;

c.) Provide the outline of an approach for privatizing California's airport system, exploring the implications of the referred literatures to the avoidance of "unexpected" consequences.

3.) Viewing privatization in a comparative perspective, indicate:

a.) In what respects, if any, the privatization of California's airports and the complete failure of the deregulation of California's electricity sector pose different issues;

b.) In what respects, if any, the reform of the airport sector in the UK and in California would differ.