ECOS 2201: Economics of Competition and Strategy
Study Guide for Midterm
1 Outline of the Test
The midterm will be held on September 15 (Thursday) from 4 pm - 6:30 pm.
You will have 2 hours to do the exam (from 4 pm to 6pm) and 30 minutes to
upload your handwritten answers. Make sure you start your upload at noon
to give yourself enough time to upload the exam.
The test will consist of 5 short answer questions/ problems, each of them
worth 20 points. All of them have to be answered handwritten and a pdf
copy of these answers has to be uploaded on canvas. Some of the questions
will be similar in difficulty level to the problems in your homework. Work
through them carefully, showing intermediate steps.
From the point of view of the test, you should focus on your problem sets,
lecture notes, and then finally the assigned readings. This is mainly a guide
on how to study for the exam, not a substitute for the lecture notes. You
are responsible for all of the lectures (1-6).
2 What to Focus On
2.1 Lecture 1
1. Use your class lecture notes, lecture notes from Robert Gibbons, the
notes on motivation from the Modern Firm by John Roberts that is
posted on Readings in Canvas.
2. In Lecture 1, we build the foundation model for understanding conflicts
of interest within an organization.
3. The model has two central features. The first is that there are exter-
nalities. A worker bears costs of effort whereas the firm gets benefits.
Second, there is an instrument w to correct this externality. By making
w contingent on y, the firm can realign the interests of a worker with
its own interests. We consider simple linear take it or leave it contracts
of the form w = s + by. s denotes salary and b is referred to as the
level of “incentives”.
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4. Know how to solve for the efficient level of effort (i.e. the level of effort
that maximizes total surplus).
5. Know how to write down the firms problem in this setting: the ob-
jective function, the choice variables (as opposed to parameters), the
participation constraint and the incentive compatibility condition.
6. Know that this problem is equivalent to the firm maximizing net surplus
(TS- worker’s reservation utility) subject to the incentive constraint.
Understand why this is the case. So there are two ways to write down
the optimization problem: one with TS − u0 as the objective function
and an incentive constraint and the other as in the point above.
7. Know that for this simple model b = 1. This can be interpreted as
selling the firm to the worker.
8. Know that when u0 = 0 and the firm is constrained to set salary non-
negative then the firm can ignore the worker’s participation constraint
in solving its problem. Here, an increase in b creates the following
tradeoff. It creates stronger incentives leading to more surplus but it
reduces the share of the surplus that the firm can keep to itself.
9. Be able to solve problem set 1.
2.2 Lecture 2
1. Use your lecture notes and the lecture notes from Robert Gibbons to
study for the test.
2. Know what extra features you have added to the basic problem to study
multitasking.
3. Know how to write down the firms problem for the multitasking prob-
lem: the objective function, the choice variables (as opposed to pa-
rameters), the participation constraint and the incentive compatibility
condition. What features are new?
4. Notice that solving the multitasking problem has exactly the same steps
as that of the basic problem in lecture 1. Be able to solve this model
repeating the same steps.
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5. There are three ways to solve this model ranging from very intuitive to
a brute force approach: the most intuitive is the geometric approach,
in the middle is the tangency approach, and the brute force approach
would involve substituting the incentive constraints into the objective
function TS− u0 so that it is only a function of b and then taking first
order conditions. Be familiar with all three.
6. Be able to interpret the optimal level of incentives b in the multitasking
model. In particular, know that it depends on alignment between the
benefit of the firm y and the performance measure p (that is the angle
θ between the vector f and the vector g.
7. Be able to solve an interpret the model of incentives with risk.
8. Be able to solve problem set 2.
2.3 Lecture 3
1. Use your lecture notes and the lecture notes from Robert Gibbons to
study for the test.
2. Know what extra features you have added to the basic problem in
lecture 1 to study a model of relational contracts.
3. Know how to write down the firms problem for the relational contracts
problem: the objective function, the choice variables (as opposed to pa-
rameters), the participation constraint and the incentive compatibility
condition, and (most importantly) the self enforcing constraint.
4. Notice that solving the relational contracts problem has exactly the
same steps as that of the basic problem in lecture 1. Be able to solve
this model repeating the same steps.
5. Understand the diagram that we use to characterize the optimal rela-
tional contract. Know the central tradeoff. Pushing the incentive level
b towards 1 increases the gains from cooperation in the future. But
it also increases the temptation to renege in the current period. The
optimal incentive level trades these two features off.
6. Be able to solve Problem Set 3.
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2.4 Lecture 4
1. Use your lecture notes and the lecture notes to study for the test.
2. Be able to work with the basic model on the informativeness principle.
Loosely this says that a variable should be used in a contract if it allows
to draw a more precise inference of effort. Be familiar with the model
we did in class where it is optimal to contract on a random variable z
that is outside of the worker’s control.
3. Know why the free rider problem arises in teams.
4. Be able to solve for the efficient levels of effort and for the effort levels
that are a Nash Equilibrium.
5. Know how getting team members to post bonds upfront can help in
getting rid of the free rider problem.
6. You will NOT be responsible in the exam for discussing the empirical
work on peer pressure. You are also not responsible for the article by
Kandel and Lazear on peer pressure or the paper by Mas and Moretti.
7. I also did not get to cover the material on career concerns and intrinsic
motivation. I will try to cover this in Week 6. You will be responsible
for understanding the basic tradeoffs involved for these models. You
will not need to know how to solve these models.
8. Be able to solve Problem Set 4.
2.5 Lecture 5
1. Know how we can use the Hotelling line to model culture in an orga-
nization. I have posted notes on this model in Canvas too.
2. Know how to solve the model with a focused structure where the firm
hires one agent to develop a project. For this case a coherent culture
is optimal.
3. Know how to solve the model with a parallel structure. Understand
that free riding is a problem which can be alleviated by hiring workers
with different beliefs/ preferences.
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4. Know the tradeoffs involved in comparing the focused structure with
the parallel one.
5. Be able to solve Problem Set 5.
2.6 Lecture 6
1. Understand the basic model of hold up and the three different cases
that we covered in class.
2. Use your lecture notes and the article by Holmstrom and Roberts.
3. Know the other factors that drive firm boundaries that we discussed in
class. See Holmstrom and Roberts.
4. Be familiar with the basic material on career concerns and intrinsic
motivation. This material was supposed to be covered in Lecture 4 but
we did not have time. I aim to do this in Lecture 6.
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