# BPP Field Exam 2009

The 2009 field exam was on June 27th 2009. 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 2008 BPP field exam had the following format:

• Morning (3 hrs): Question A.1 or A.2 (1hr), Question B.1 or B.2 (2hrs)
• Afternoon (3 hrs): Question C (1.5hrs), Question D (1.5hrs)

The best guess as to question originators is:

• A.1 - Mowery
• A.2 - Dal Bo
• B.1 - Morgan
• C - de Figueiredo
• D - Spiller

Complete and partial anwsers to some questions are provided on the BPP Field Exam 2009 Answers page.

## Questions

### Question A1: R&D Integration

U.S. firms were among the first large industrial enterprises to integrate backward into R&D in the lath 19th and early 20th centuries, and many large U.S. froms maintained large in-house research facilities into the 1970s and 1980s. Since the 1980s, according to some observers, U.S. firms have "externalized" a larger share of their R&D and related activities, relying on "open innovation," described by Chesbrough as a new model for 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.) What factors led U.S. firms to integrate into R&D in the late 19th/early 20th centuries and how if at all did firms exploit intrafirm and external sources of technology during the 1900-1940 period?

b.) What factors explain the asserted "externalization" of corporate R&D in the 1980s and 1990s? How do these factors operate across different industries?

c.) What indicators support or undermine the argument that U.S. firms have indeed "outsourced" their R&D and other innovation-related activities?

Based on your answers to (a) - (c) develop a theoretical framework to predict the evolution of infrafirm and external R&D within the innovative strategies of large U.S. firms during the next 10 years (2008-2018).

### Question A2: Competition, Innovation and Antitrust

I. Two firms, A and B, produce an undifferentiated good: a cell phone with two features: white color and a battery that allows the phone to function for four hours. Currently, both firms compete in prices and make zero profits. There are no substitutes. These are the only cell phones in existance. One day, firm A produces an innovation. Consider alternatively the following two scenarions, while assuming that there are no entry costs.

a.) Firm A's innovation - which is incredibly cheap - consists in making its phone red.

b.) Firm A's innovation extends the battery life of its product to 6 hours.

Explain what you expect to happen in each scenario to the number of firms, to prices, and to profits in the cell phone market.

II. Suppose you observe a duopolist market where firms make positive profits. Someone in the Department of Justice decides to act. His argument is that, it being known that the firms compete in prices rather than quantities, the positive profits indicate some anticompetitive behavious, or the presence of some substandtion barrier to entry in the form of entry costs. You are asked to issue a recommendation endorsing the investigation. Would you object, on any grounds, to the investigation being launched?

### Question B1: Work contracts with a continuum of workers

A firm is hiring from a continuum of workers with unit mass. Workers are heterogenous in their cost of effort. A typical worker has a private cost type $c\,$ where $c\,$ is uniformly distributed on the interval $[\frac{1}{2},1]\,$. A worker of type $c\,$ who puts in effort $e\,$ pays a personal cost of effort $ce^2\,$. All workers are risk-neutral so their payoffs are simply: $\pi_w = m -ce^2\,$ where $m\,$ is the compensation paid to the worker by the firm,

The firm's objective function is to maximize the sum of the efforts on the part of the workers. Effort is observable; however the worker's cost type is not. Furthermore the workers are protected by limited liability, so the firm cannot pay negative amounts to the workers. That is, the total expenditure of the firm on wages can be, at most, $\frac{1}{2}\,$. A firm derives benefit only from effort - not from any unspent portion of its budget.

a.) Suppose that the firm chooses a direct mechanism and that workers are free to opt out of any contract. In a direct mechanism, workers announce a type and then recieve a contract consisting of an effort level and transfer amount conditional on their announced type. Write down the firm's optimization problem.

b.) Find the optimal compensation scheme and determine equilibrium effort and total effort.

Now suppose that the firm instead offers a simple pass/fail scheme. Specifically, it offers a contract where it specifies an effort threshold $e^*\,$ and a transfer amount $t^*\,$. In this scheme any worker who produces effort level $e^*\,$ or more gets paid $t^*\,$. As before, the scheme must satisfy the budget constraint.

c.) Write down the firm's optimization problem for this scheme.

d.) Derive the optimal contract in this class of contracts and determine the equilibrium effort.

e.) Provide an elasticity interpretation for the optimality condition of the pass/fail scheme.

f.) Which contract is better? Why?

### Question B.2: Opportunistic sellers

Consider an economy with many identical Buyers that can each engage in a transaction with one of many sellers. For concreteness, imagine that there are more buyers than sellers and that the market for transactions must clear. The transaction can either succeed or fail. Each buyer’s value of "success" is 1 and of "failure" is 0.

There are two kinds of Sellers. A proportion $1 - \beta\,$ are "good" and they succeed with probability $p \gt 0\,$. A proportion $\beta\,$ are "opportunistic" and can choose some effort, $e \in [0,1]\,$ at a personal cost of $c(e)\,$ where $c'(0) = 0, c'(1) = \infty\,$ and $c''(e) \gt 0 \;\forall e \ge 0\,$. The opportunistic types succeed with probability $ep\,$.

The economy operates for 2 periods. Sellers live for two periods but a new cohort of buyers is active in each period, and second period buyers can observe the first period outcome of transactions.

Effort and types are not observable to buyers so that in each period buyers who wish to transact with sellers will pay a price for the transaction in advance, after which the service/good is delivered and failure/success is observed.

a.) What level of e would maximize total surplus?

b.) An equilibrium is defined by a price $w_1\,$ that buyers pay sellers in the first period, and history contingent prices $w_2(S)\,$ and $w_2(F)\,$ (for Success and Failure respectively) that buyers pay sellers in the second period, so that expectations about outcomes are correct, and sellers best respond to current and future outcomes. Is there an equilibrium where opportunistic sellers exert the level of $e\,$ you found in (a) in each period? If so, show it. If not, explain why not.

c.) Is there an equilibrium in which opportunistic sellers choose no effort in both periods? If so, show it. If not, explain why not.

d.) Find the equilibrium of this market, and argue that it is unique.

e.) If the sellers exert effort in the equilibrium you found in (d) in some period, what market mechanism provides them with incentives? How would you interpret his?

### Question C: Bargaining over Policy

Consider the role of the US President in policy bargaining with the US Congress. Amongst the institutional tools the President has is the Presidential veto. This question asks you to explore the nature of this instrument.

Part I. For the following 2 cases, (1) outline how you would set up a model to study the institution, (2) discuss what you think may be the main interesting propositions, and (3) explain your logic for how they would be derived. (Note: you do not need formal proofs of your propositions, but you do need to sketch them and/or explain why you believe they will hold if formally derived).

a.) One puzzle in the literature is: If a veto is costly to both the President and Congress, why is the veto ever observed in practice? Why can't a bargain be struck which avoids the "suboptimal losses" from the actual exercise of a veto? Outline a model in which vetoes are observed in equilibrium. Discuss what you believe are the primary propositions which will be derivable from this model.

b.) Another question about presidential power is: How do the existence of a veto player affect multi-lateral bargaining (in a legislature)? Outline a model of bargaining in legislatures with a Presidential veto. How will the inclusion of a Presidential veto affect you predictions under different institutional settings? In other words, compare how your results compare across different institutional settings (e.g. open versus closed rules, finite versus infinite horizon).

Part II. For one of the above cases, describe a strategy for testing your model. Included in this discussion should be:

a.) What are the main empirically testable hypotheses you would test?

b.) What would be your unit of analysis?

c.) What data would you use?

d.) What empirical model would you use?

e.) How would you identify causality?

### Question D: Soft Drink Organization

Soft drink production has since the beginning of the industry in the early 1900s been organized in two segments: Concentrate manufacturers (CM) and bottlers. The CMs, having the TradeMark and the secret to the concentrate formula, grant exclusive territories to particular bottling companies. The relation between the CMs and the bottlers is governed by Exclusive Bottling Arrangements (EBA) which stipulates the respective obligations of the parties. In that regard, the EBA grants the bottler perpetual exclusive bottling and distribution rights for a particular set of soft drink products, demands from the bottler to maintain certain quality standards, and to purchase concentrate exclusively from the CM at a certain price (usually a percentage of sales). The EBAs also require the bottler to undertake marketing efforts, usually following agreed upon annual marketing campaigns, with the CM providing part of the financing for the marketing.

Although by the 1920s there were thousands of bottlers, by the late 1960s the number of bottlers shrank to just a few hundreds. In the 1980s the CMS started to enter into conflicts with bottlers and the CMs started to acquire bottlers. Today, for example, Coca Cola Enterprises is the largest drink bottler, and it is a subsidery of Coca Cola.

I. Economic rationale for the EBAs

a.) Provide an economic rationale for the EBAs that can explain their main features:

• Perpetual
• Granting of exclusive bottling and distribution territories
• Requiring marketing coordination by the bottlers and financial support by the CMs

i.) Explain what considerations would move a franschisor to grant perpetual contracts and exclusive territories

ii.) Discuss the tradeoffs associated with these features

b.) Develop an empirical test of your framework in (a) and (b).

II. Conflicts

c.) Provide an economic rationale for the consolidation that took place in the bottling segment.

d.) Provide an economic rationale for the need of the CMs to buy up some of their bottlers

e.) Develop an empirical test that is consistent with (c) and (d).