Slide 1

Managerial Economics

PGDM : 2015 17 Term 1 (June September, 2015)(Lecture 03) OrganizationNot for Profit OrganizationGovernment AgencyBusiness OrganizationSole ProprietorshipPartnershipsCorporationCategories of Organization2

Business Organization3

Business OrganizationResource OwnerOrganizing Resources: Land, Labor, Capital etc.Income: Rent, Wage, and InterestPurchase of Goods and Service produced and distributed by the firmGovernmentTAXPublic Services such as Defense, Education, HealthPosition of a Business Organization in an Economy????????????44Different Theories to Understand the Nature of the Firm/ Business Organization5

Different Theories to Understand the Nature of the Firm / Business Organization6

7Transaction Cost Theory

8Transaction Cost Theory

9Transaction Cost Theory

Why does a firm exist: Transaction Cost TheoryNote that, a production or a distribution process consists of multiple steps.

It is inefficient and costly for an entrepreneur to enter and enforce contracts with the owners of the required resources for each separate step of production and distribution.

It is less costly and advantageous to both parties - entrepreneur and resource owners - if there is a longer term, broader contract between them, i.e., a General Contract.

A General Contract internalizes many transactions through performing many functions within the organization i.e. the Firm.

Moreover, operating a firm, an entrepreneur can save sales tax and can avoid those Government Regulations which are only applicable to transaction between firms.

10What is Optimal Level of Expansion?So, if internalization reduces transaction cost then, should a firm expand indefinitely?Answer is NO. But Why?It is very important to decide on the optimal size of firm since expansion beyond the optimal point leads to Diseconomies of Scale i.e., increase in average cost with the increase in output.Up to a certain point this diseconomies of scale can be avoided by establishing a number of semi-autonomous divisions i.e., through decentralization.After a certain point on the expansion path of the firm, the distance between top management from each division starts increasing. This in turn limits the managements ability to effectively control and direct the operations of the firm and impose sufficient diseconomies of scale to limit the growth of the firm.

11We will have an elaborate discussion on Diseconomies of Scale while discussing Production Economics11ExampleModern corporations allow firm managers to have no participation (or only limited ownership participation) in the profitability of the firm.Shareholders are Principals, managers are AgentsTwo common problems: Often hard to observe managerial effort and Random disturbances in team performance (luck versus effort?)

Consequence: The Principal-Agent ProblemShareholders (principals) want profit/value to be maximizedManagers (agents) want individual utility/benefit to be maximized through receiving more leisure & financial securityIt is very likely that there will be conflict between the interest of these two groupsThis conflict of interest leads to the Principal-Agent Problem

12Divorce between Ownership and Control: Management Utility Maximization Problem1213Agency Theory/ Agency Problem

Read Section 2.4.2 for DetailsRead Section 2.4.1 for DetailsRead Section 2.4.2 for Details14Control Measures

Read this Case Study from the Material Sent with this PPT.15Motivation Theory

16Property Rights Theory