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practicefinal - AEM 424 Final Review Questions Fall 2004 1...

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AEM 424 Final Review Questions Fall 2004 1. a. Explain what is meant by a specialized asset. Asset specialized to a particular task. Worth more in that use than it its next best use. b. Use the following example to show how specialized investments can create quasi-rents and the threat of hold-up. A utility company decides to build a power plant right next to a coal mine (coal is the energy source for electricity). The power plant is specialized (specific) to the coal mine, as it can incur lower transport costs as a result of location. But, this creates a quasi rent, which is the difference in the profits of the plant buying coal from the mine next door, versus buying coal from elsewhere. The difference in transport costs determines the size of the quasi rent. The quasi rent in turn leads to the possibility of hold up, as the coal mine may try to raise prices to capture some of the quasi rent from the power plant. The most they could raise prices by is the difference in transport costs, i.e the amount of the quasi rent. c. Given the threat of hold up, why do firms invest in specialized assets? They lower costs and/or increase quality. Generally needed for efficient high-volume production. d. How does vertical integration help to solve the hold-up problem? Primarily by changing incentives – buyer and supplier division within the same firm both have incentive to increase firm performance. Can be strengthened by tying financial compensation to firm performance. Also, disputes between divisions can be resolved much more easily then disputes between firms (have to go to court). Also, buyer and supplier divisions realize that they have to cooperate because they are stuck with each other (long term), while independent firms may not value long term relationship. e. In what other ways might a firm resolve the threat of hold-up? long-term contracts, reputation
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2. a. Is diversification to reduce risk a value creating strategy? Explain. No, shareholders can do so on their own. b. Does anybody benefit from reducing risk via a firm’s diversification? Explain. Yes, managers. They have more job security with lower risk (less chance of bad performance leading to bankruptcy, less variance in performance-based pay). c. Is diversifying into more rapidly growing or more profitable industries a value creating strategy?
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