Lecture 13Lecture 13Economic Theory of the Economic Theory of the FirmFirm There are two views of the firm:There are two views of the firm:

– Neoclassical theoryNeoclassical theory Firm is a calculating entity, that makes decisions, Firm is a calculating entity, that makes decisions,

buys inputs, making output, and selling for profit for buys inputs, making output, and selling for profit for lossloss

– Property rights theoryProperty rights theory Firm is a collection of contracts between owners of Firm is a collection of contracts between owners of

resources, who wish to combine some portion of resources, who wish to combine some portion of their resources, for some period, for some purposetheir resources, for some period, for some purpose

Why two theories?Why two theories? Two classes of problems:Two classes of problems:

– How do How do allall firms react to particular events? firms react to particular events? Changes in input pricesChanges in input prices Changes in output pricesChanges in output prices

Why are there different Why are there different typestypes of firms doing of firms doing different things?different things?– Partnerships, proprietorships, corporations, Partnerships, proprietorships, corporations,

joint ventures, etc.joint ventures, etc.

The two views complement each otherThe two views complement each other

Basics of the neoclassical Basics of the neoclassical firmfirm The firm — headed by the entrepreneur — makes decisionsThe firm — headed by the entrepreneur — makes decisions

– What to produce?What to produce?– When and how to produce it?When and how to produce it?– How much to produce?How much to produce?– What is its price?What is its price?

The firm has a production functionThe firm has a production function– Relates inputs and outputs — a recipe, if you willRelates inputs and outputs — a recipe, if you will

q = q (x,y,z)q = q (x,y,z) q is outputq is output x, y, z are inputsx, y, z are inputs

– The exact form depends on technology, state of knowledge, The exact form depends on technology, state of knowledge, etc.etc.

A production functionA production function

Here is a production function that is a mechanical Here is a production function that is a mechanical view of production—labor, supplies and capital:view of production—labor, supplies and capital:– 1 shovel of cement1 shovel of cement– 3 shovels of sand3 shovels of sand– 5 shovels of stone5 shovels of stone– 1 gallon of water1 gallon of water– Use labor and hoe to mix cement, sand, and stone Use labor and hoe to mix cement, sand, and stone

for 1 minutefor 1 minute– Add waterAdd water– Use labor and hoe to mix for two minutesUse labor and hoe to mix for two minutes– Yield is three gallons of wet concreteYield is three gallons of wet concrete

Basics of Property Rights Basics of Property Rights Theory: Why do firms Theory: Why do firms exist?exist? Neoclassical theory focuses on the mix of a variety of Neoclassical theory focuses on the mix of a variety of

factors of production (“inputs”), called capital, labor, etc.factors of production (“inputs”), called capital, labor, etc.

Property Rights theory asks if productivity of these Property Rights theory asks if productivity of these factors should depend on whether we hire them out or factors should depend on whether we hire them out or use them ourselves—who owns what and what are the use them ourselves—who owns what and what are the incentives?incentives?

We see a variety of choices in the real worldWe see a variety of choices in the real world– Some use theirs and theirs aloneSome use theirs and theirs alone– Some rent out for use by othersSome rent out for use by others– Some do the rentingSome do the renting

The firm vs. the marketThe firm vs. the market The line between the market vs. command and controlThe line between the market vs. command and control

– The market relies on spot prices to provide information The market relies on spot prices to provide information and induce decisionsand induce decisions

– The firm relies on command and control within the The firm relies on command and control within the context of “long term” contracts to inform and inducecontext of “long term” contracts to inform and induce

The tradeoff:The tradeoff:– Market is informationally efficient Market is informationally efficient – The firm is contractually efficientThe firm is contractually efficient

The balance between these two determines the The balance between these two determines the margin of choice between the firm and the marketmargin of choice between the firm and the market

What Kind of Organization?What Kind of Organization?

A key role of managers is to procure A key role of managers is to procure inputs in the least cost manner—inputs in the least cost manner—including providing incentives for including providing incentives for workers to be productive.workers to be productive.

If this is not accomplished, costs will If this is not accomplished, costs will be higher than needed and the firm be higher than needed and the firm will lose profits and perhaps go out will lose profits and perhaps go out of business in a competitive market.of business in a competitive market.

Methods of Obtaining Methods of Obtaining InputsInputs

Three major methods:Three major methods:1.1. Spot market or spot exchange—Spot market or spot exchange—

When buyers and sellers of inputs meet, When buyers and sellers of inputs meet, exchange, but may not deal again. Benefit: exchange, but may not deal again. Benefit: this allows us to deal with specialized this allows us to deal with specialized sellers, usually with low transaction costs. It sellers, usually with low transaction costs. It means we do not have to integrate the means we do not have to integrate the seller into the firm. Possible problem: seller into the firm. Possible problem: exploitation by seller who knows we are exploitation by seller who knows we are ignorant or need supply badly.ignorant or need supply badly.

Methods of Obtaining Methods of Obtaining InputsInputs

Three major methods:Three major methods:2. Contracts—2. Contracts—

Legally based extended relationship Legally based extended relationship between buyer and seller.between buyer and seller.Benefits: specialization, ability to Benefits: specialization, ability to terminate sellers who do not perform, terminate sellers who do not perform, reduction in opportunistic behavior reduction in opportunistic behavior compared to spot markets. Problem: compared to spot markets. Problem: costly in complex environments.costly in complex environments.

Methods of Obtaining Methods of Obtaining InputsInputs

Three Major Methods:Three Major Methods:3. Vertical Integration—3. Vertical Integration—

When a firm chooses to produce an When a firm chooses to produce an input internally rather than contract input internally rather than contract with outsiders. Benefits: reduced with outsiders. Benefits: reduced opportunistic behavior by outsiders opportunistic behavior by outsiders and fewer contracting costs. Problems: and fewer contracting costs. Problems: lost specialization and increased lost specialization and increased organizational costs.organizational costs.

Methods of Obtaining Methods of Obtaining InputsInputs

Summary:Summary:Is there substantial specialized Is there substantial specialized

investments relative to contracting investments relative to contracting costs? If no—likely to use spot market.costs? If no—likely to use spot market.

If yes—is the cost of contracting high If yes—is the cost of contracting high relative to the cost of integration? If relative to the cost of integration? If yes—vertical integration; if no—yes—vertical integration; if no—contracts with outside suppliers.contracts with outside suppliers.

Major Drawback of Firms: Major Drawback of Firms: Agency CostsAgency CostsThe agency problem (and cost it imposes) arises from the The agency problem (and cost it imposes) arises from the

problem of the separation of ownership and control.problem of the separation of ownership and control.

Owners of firms are interested in profit maximization.Owners of firms are interested in profit maximization.

Managers and other employees are interested in Managers and other employees are interested in maximizing own self-interests. maximizing own self-interests.

How do we give managers an incentive to act as if they How do we give managers an incentive to act as if they were owners of the firm?were owners of the firm?

How do we get employees to not shirk—that is, work as How do we get employees to not shirk—that is, work as hard as they can in the manner the owners would want.hard as they can in the manner the owners would want.

Agency CostsAgency Costs

Who gets what — or thinks they deserve Who gets what — or thinks they deserve something — is often a part of what are something — is often a part of what are classified as Agency Costs or Agency classified as Agency Costs or Agency Problems.Problems.

Agency costs exist as a problem Agency costs exist as a problem whenever a principal hires an agent to whenever a principal hires an agent to act on his behalf.act on his behalf.

Solving these problems is a key Solving these problems is a key managerial problem in managing managerial problem in managing personnel and in controlling costs.personnel and in controlling costs.

Agency Costs . . .Agency Costs . . .

These are a problem because we are These are a problem because we are human. If we “cheat” ourselves, then no one human. If we “cheat” ourselves, then no one else bears the cost. So we never cheat else bears the cost. So we never cheat ourselves (except after the fact — we may ourselves (except after the fact — we may think so).think so).

It is natural for us to want to exploit others It is natural for us to want to exploit others — get others to pay more than they agreed — get others to pay more than they agreed to pay or produce less than we agreed to to pay or produce less than we agreed to produce. A divergence in interest between produce. A divergence in interest between principal and agent.principal and agent.

Monitoring, Signals and Monitoring, Signals and ContractsContracts Assume a company will need an average of Assume a company will need an average of

50 hours of legal work a year at $100/hour.50 hours of legal work a year at $100/hour. The law firm has an incentive to inflate the The law firm has an incentive to inflate the

number of hours to maybe 70 hours.number of hours to maybe 70 hours. Company knows that, so pays an expert to Company knows that, so pays an expert to

monitor the law firmmonitor the law firm Law firm knows it is being monitored so has Law firm knows it is being monitored so has

incentive to monitor itself.incentive to monitor itself. Parties may reach fixed price contract to avoid Parties may reach fixed price contract to avoid

monitoring costs & send right signal.monitoring costs & send right signal.

MonitoringMonitoring Because we have incentives to Because we have incentives to shirkshirk – take more – take more

than we should or work less than we should – others than we should or work less than we should – others have to have to monitormonitor us. Monitoring is costly (which us. Monitoring is costly (which means it is sensible to accept some losses — means it is sensible to accept some losses — pencils).pencils).

Usually there is unequal (asymmetric) information Usually there is unequal (asymmetric) information between two parties — one knows more than the between two parties — one knows more than the other and can exploit that.other and can exploit that.

Ex.: Person selling used car.Ex.: Person selling used car.Lawyer doing legal work.Lawyer doing legal work.Person choosing insurer (buyer exploits seller)Person choosing insurer (buyer exploits seller)

Monitoring & BondingMonitoring & Bonding

How do we assure customers that we will How do we assure customers that we will not exploit them unfairly—that they will pay not exploit them unfairly—that they will pay a reasonable, market price?a reasonable, market price?

Various devices:Various devices:Fixed price contracts; Bonds; Warranties;Fixed price contracts; Bonds; Warranties;Future price guarantees. Future price guarantees. Less formal: Reputation (evidence is strong Less formal: Reputation (evidence is strong

that this matters in market)that this matters in market)

3 Levels of Monitoring 3 Levels of Monitoring FirmsFirms

Markets discipline firms in three ways:Markets discipline firms in three ways:1.1. Internally: Poor performing firms Internally: Poor performing firms

usually fire top management.usually fire top management.2.2. Market for Corporate Control: Poor Market for Corporate Control: Poor

performers replaced by new owners performers replaced by new owners who pay a premium to get assets.who pay a premium to get assets.

3.3. Bankruptcy or other exit.Bankruptcy or other exit.

The entrepreneurThe entrepreneur What determines who is giving the orders and What determines who is giving the orders and

who is receiving?who is receiving?

Suppose there is some factor called Suppose there is some factor called entrepreneurial entrepreneurial capacity (or capacity (or entrepreneurial entrepreneurial ability)ability)– Possessed by each of usPossessed by each of us– NOT marketable (and so has no opportunity NOT marketable (and so has no opportunity

cost)cost)– The returns to this factor vary among people The returns to this factor vary among people

and so determine whether they bother to use it and so determine whether they bother to use it or notor not

The entrepreneur’s The entrepreneur’s rewardreward Capital and labor are paid contractually—by the hour, or Capital and labor are paid contractually—by the hour, or

the output, or whateverthe output, or whatever

Entrepreneur receives a Entrepreneur receives a residualresidual payment on a payment on a noncontractual basisnoncontractual basis– Payment for Payment for monitoringmonitoring (“managing”) K & L (“managing”) K & L– If done well (or just guesses right) the payment is positive; If done well (or just guesses right) the payment is positive;

if not, payment is negativeif not, payment is negative

Profit is difference between revenues and costs Profit is difference between revenues and costs – The factor E has no opportunity costThe factor E has no opportunity cost

Thus profit is the payment EThus profit is the payment E Profit is reward for making costs lower than other firms’ Profit is reward for making costs lower than other firms’

profitsprofits

Entrepreneurs and their Entrepreneurs and their FirmsFirms Key Managerial Problem:Key Managerial Problem:Giving employees incentives to act Giving employees incentives to act

as ifas if they are owners. they are owners.In general: Decentralization of In general: Decentralization of

Authority required and movement Authority required and movement has been in this direction; has been in this direction; especially in knowledge-based especially in knowledge-based production.production.

Decentralization: Pros & Decentralization: Pros & ConsCons Empowering workers and managers is a Empowering workers and managers is a

good concept--good concept--BENEFITS:BENEFITS:

1. More effective use of local knowledge — 1. More effective use of local knowledge — those closest know the most – quick decisionsthose closest know the most – quick decisions2. Conservation of time of senior management 2. Conservation of time of senior management — — important people cannot know or do everythingimportant people cannot know or do everything3. Training & motivation for local managers —3. Training & motivation for local managers —helps attract and keep good managers and helps attract and keep good managers and train future top managerstrain future top managers

Decentralization . . . Decentralization . . .

A good idea but obviously not perfect--A good idea but obviously not perfect--COSTS:COSTS:

1. Agency costs—1. Agency costs—shirking; self-dealing—so control and shirking; self-dealing—so control and monitoring measures neededmonitoring measures needed

2. Coordination costs and failures—2. Coordination costs and failures—duplication; pricing errorsduplication; pricing errors

3. Less effective use of central information—3. Less effective use of central information—local managers cannot know all local managers cannot know all

information information held by the central held by the central managers, so have inferior managers, so have inferior knowledgeknowledge

Decentralizing: Team Decentralizing: Team DecisionsDecisions Create teams composed of people with different Create teams composed of people with different

area expertise empowered to make decisions—area expertise empowered to make decisions—Ex.—Hallmark Cards has teams of art, design, Ex.—Hallmark Cards has teams of art, design, production and marketing assigned by holiday production and marketing assigned by holiday with decision rights rather than move produce with decision rights rather than move produce from functional area to area—cut time in half.from functional area to area—cut time in half.

Benefits—Improved use of dispersed specific Benefits—Improved use of dispersed specific knowledge and employee “buy in” due to better knowledge and employee “buy in” due to better information, more cooperation & less blame.information, more cooperation & less blame.

Costs—Collective-action problems and free-rider Costs—Collective-action problems and free-rider problems.problems.

Decision Management & Decision Management & ControlControl

1. Initiation—proposals to use firm resources and the 1. Initiation—proposals to use firm resources and the structuring of contractsstructuring of contracts

2. Ratification—choice of initiatives to be 2. Ratification—choice of initiatives to be implementedimplemented

3. Implementation—execution of ratified decisions3. Implementation—execution of ratified decisions4. Monitoring—measurement of performance of 4. Monitoring—measurement of performance of

decision agents and implementing rewardsdecision agents and implementing rewardsRemember Remember — agents (managers within a firm) do not — agents (managers within a firm) do not

bear the full cost of their actions, so cannot be bear the full cost of their actions, so cannot be delegated both decision management and control delegated both decision management and control — hierarchy still necessary. Make authority and — hierarchy still necessary. Make authority and lines of control lines of control clearclear to avoid confusion. to avoid confusion.

Questions on the FirmQuestions on the Firm

If firms profit maximize, as If firms profit maximize, as economic theory predicts, then in economic theory predicts, then in a highly competitive industry will a highly competitive industry will there be much discrimination there be much discrimination against minorities or women?against minorities or women?

How Do We Overcome How Do We Overcome Agency Costs?Agency Costs? The larger the organization, or the The larger the organization, or the

greater the distance from the owners greater the distance from the owners to the workers, the more likely that to the workers, the more likely that agency costs will become significant agency costs will become significant —large corporation look more like an —large corporation look more like an inefficient government agency. What inefficient government agency. What economic incentives do firms take to economic incentives do firms take to try to give workers proper try to give workers proper incentives?incentives?

Focus of the BusinessFocus of the Business

Conglomerates are firms that Conglomerates are firms that contain many unrelated business contain many unrelated business activities. The argument is that activities. The argument is that this allows diversification of the this allows diversification of the portfolio in the firm. What is the portfolio in the firm. What is the downside of such arrangements?downside of such arrangements?

Question on Team Question on Team IncentivesIncentives Suppose different numbers of people are Suppose different numbers of people are

assigned to pull a rope “as hard as you assigned to pull a rope “as hard as you can.”can.”

One person pulls the rope.One person pulls the rope. Three people pull the rope together.Three people pull the rope together. Eight people pull the rope together.Eight people pull the rope together. How does the pulling force (work effort) How does the pulling force (work effort)

per person change across these three per person change across these three cases?cases?

Large Organization with Large Organization with Simple MonitoringSimple Monitoring

Mary Kay Cosmetics grew from sale Mary Kay Cosmetics grew from sale of $200,000 in 1963 to over $600 of $200,000 in 1963 to over $600 million in 1993, 30 years later. The million in 1993, 30 years later. The product is common and very product is common and very competitive. The key to growth was competitive. The key to growth was measurement of employee effort measurement of employee effort and rewards. What was it?and rewards. What was it?

Is Decentralization the Is Decentralization the Key?Key?

There has been much discussion of the problems There has been much discussion of the problems of centralized control and the benefits of a of centralized control and the benefits of a decentralized organizationdecentralized organization

These are some benefits of decentralized These are some benefits of decentralized decision making:decision making:1.1. More effective use of local knowledgeMore effective use of local knowledge2.2. Conservation of time of senior managersConservation of time of senior managers3.3. Motivation for local managersMotivation for local managersWhat are the costs imposed by these same What are the costs imposed by these same benefits?benefits?

Incentives of ManagersIncentives of Managers

In the fast-food industry, about 30% of the In the fast-food industry, about 30% of the stores are company owned and are run by stores are company owned and are run by a salaried company manager. About 70% a salaried company manager. About 70% of the stores are run as franchises by of the stores are run as franchises by owner-operators who split profits with the owner-operators who split profits with the parent company. 1) Which kind of store parent company. 1) Which kind of store would you think would tend to be more would you think would tend to be more profitable? profitable? 2) Would you expect employees to see a 2) Would you expect employees to see a difference in the managers?difference in the managers?