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2008final - PART A Answer all questions Each question is...

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PART A: Answer all questions . Each question is worth 10 marks. 1. What are the characteristics of a °strategic move±? In the Dixit model of Entry De- terrence, the Incumbent ²rm±s investment in capacity is a sunk cost. What are sunk costs? Explain the importance of the sunk nature of the costs to the strategic move of the Incumbent ²rm in the Dixit model. 1
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2. The compensation package for a manager of a ²rm consists of a base salary, s and a bonus, b s + b The base salary is paid to the manager regardless of the ²rm±s performance. The bonus is only paid to the manager if the manager achieves a particular performance target. If the manager exerts normal e/ort, the probability of achieving the performance target is 1 3 . If the manager exerts high e/ort, the probability of achieving the performance target is 5 6 . The manager views extra e/ort (increasing e/ort from normal to high) as costly since it requires the manager to work long hours. The manager requires an extra $100 ; 000 in compensation to be willing to exert high e/ort. Write out the Incentive Compatibility Condition/Constraint that must be satis²ed in order to induce the manager to exert high e/ort. Determine the smallest value of b that will induce the manager to exert high e/ort. 2
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3. What is a ³cheap talk´equilibrium. Describe the characteristics of a game that will tend to increase the likelihood of a ³cheap talk´equilibrium. Find the ³cheap talk´
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