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Economics of Organization

Problem Set 1
Suggested Solutions


See lecture slides.


B type candidates would apply with probability 1 and the company would incur the costs of
conducting the test.
b) Given that the best alternative is wA, A types would apply if
qw + (1-q) wA >= wA w>= wA.
Given that the best alternative is VB, B types would apply if
(1-q)w + qVB >= (1-q)wA + qVB > VB
If both types apply, the probability that a candidate that passes the test is of type A is:
P(A|Pass) = pq / (pq + (1-p)(1-q))
To see this note:
P(Pass|A)=q, P(NPass|B)=q, P(Pass|B)=1-q, P(NPass|A)=1-q, P(A)=0.25, P(B)=0.75
P(Pass)= P(Pass|A) P(A) + P(Pass|B) P(B) = 0.25q + 075(1-q)= 0.75-0.5q
P(NPass)= P(NPass|A) P(A) + P(NPass|B) P(B) = 0.25(1-q) + 075q= 0.25+0.5q
Using Bayes theorem:
P(A|Pass)=[P(Pass|A)P(A)]/P(Pass) = 0.25q/(0.75-0.5q) = q/(3-2q)
P(B|Pass)=[P(Pass|B)P(B)]/P(Pass) = 0.75(1-q)/(0.75-0.5q) = (3-3q)/(3-2q)
Which allows deriving the expected payoff from employing a candidate that passes the
E(V|Pass) = P(A|Pass)VA + (1- P(A| Pass))VB = [q/(3-2q)] VA +[(3-3q)/(3-2q)] VB
For Finmax it is profitable to pay w if w E(V|Pass). Given that A types only apply if wwA, it
is profitable for Finmax to offer a salary that attracts A types only iff wA E(V|Pass).
Otherwise it is not profitable for Finamax to have the tests in place. This means that if the
test is not sufficiently precise (E(V|Pass)<wA), it is not worthwhile having the test at all.
The test is only worthwhile if
[q/(3-2q)] 40 +[(3-3q)/(3-2q)] 20 >= 30
4q +6 -6q>= 9 6q q >=
Below this value, there is no equilibrium wage that allows hiring A types, even if the test
could be conducted at no cost.
Given the competition for analysts, Finmax has to pay
w = E(V|Pass) = [q/(3-2q)] 40 +[(3-3q)/(3-2q)] 20
which varies between w=wA=30 for q = and w=40 for q=1
which means Finmaxs payoff is:
q (E(V| Pass)-w) c = q (E(V| Pass)- E(V| Pass)) c = - c
If the labor market is competitive, it is better to pay vB and hire B types.


w2 wB =15
w1 + (1-s)w2 + swB 2wB


w2 wA = 30
w1 + s w2 + (1-s)wA 2wA



If A types apply, (3) and (4) have to hold. Note that if w2 wA, w2 wB has to hold
because if A types apply, B types also apply. For B types not to apply, (2) must not
It is possible to show that if (4) (2) for w1=0, (4) (2) for all w1. This is the case for all
s>0.5 because:
(2) can be expressed as: w1/(1-s) + w2 (2-s)wB/(1-s)
(4) can be expressed as: w1/s + w2 (1+s)wA/s
Therefore it is sufficient to verify that if s=2/3, (4) (2)
If w1=0:
(4) becomes w2 ((1+s) wA) /s = (5/2)*30 = 75
(2) becomes w2 (2-s)wB/(1-s) = 4 * 15 = 60
as w1>0 increases, the left hand side of equation (2) increases more tan that of
equation (4). If (4) holds, also (2) holds, which means it is imposible to ensure only A
types apply to take the test. The reason is that the test is not sufficiently precise to
attract A types.
d) This is the case if w1=0.
(4) then turns into w2 63.33 and (2) into w2 165, which means for sufficiently low w1
there is range of w2 for which A types want to enter the probationary period and B
types dont.
As w1 increases, this range shrinks until disappearing. The values of w1 for which it will
be imposible to only attract A types is
w2 (w1) = w2 (w1), where
w2 = ((1+s) wA) /s w1/s = w2 =(2-s)wB/(1-s) w1/(1-s) w1 = 11.4735
Denote this value of w1, w1*. The values for which only A types assume the
probationary period are w1<w1*, w2 w2 , y w2<w2 .
The expected payoff is simply
in our example: 40*1.9=76
The expected costs are
w1 + sw2
Obviously Eurofin does not want to pay more than necessary to attract A types (and
not the B types), so it fixes w1 and w2 such that:
w1 + sw2 +(1-s) wA=2wA w1 + sw2 = wA (1+s) in our example: 30*1.9= 57
So the expected payoff is (1+s)(VA wA) = (1+s)10 =19


We have derived that for values w1 < w*1 = 11.4735, w2 (w1) < w2 (w1), which means
any w2 that attracts B types also attracts A types. That means it has to be a
combination that satisfies the following conditons:
w1 >11.4735
w2 <((1+s) wA) /s w1/s
w2 (2-s)wB/(1-s) w1/(1-s)
Expected payoff
Income: VB(1+(1-s)) = VB(2-s)
example: 20(1.1)= 22
Expected cost: w1 + (1-s)w2 = (1+(1-s))wB = (2-s)wB
example: 15(1.1)= 16.5
Expected payoff: VB(2-s) (2-s)wB = (2-s)(VB wB) = (2-s)5 = 5.5
Note that in this case having a propationery period doesnt make sense. It is better to
offer wB in both periods and to obtain 2(VB-wB) = 10


Now (1+s)10 < (2-s)10 < 2*10

In this case B types are sufficiently cheap (relative to their productvity), which means it
is more profitable to hire them than to attract the A types and have the probationary
period in place.



=0.5583 generates a profit of exactly 3.000 for the good franchisees and a loss for
the bad franchisees. Any below this value and above =0.4111 only attracts good
=0.5416 generates a profit of exactly 5.000 for the good franchisees and a loss for
the bad franchisees. Any below this value and above =0.4111 only attracts good