Lecture 13 Economic Theory of the Firm

1. Lecture 13Economic Theory of the Firm • There are two views of the firm: • Neoclassical theory • Firm is a calculating entity, that makes decisions, buys inputs, making output, and selling for profit for loss • Property rights theory • Firm is a collection of contracts between owners of resources, who wish to combine some portion of their resources, for some period, for some purpose

2. Why two theories? • Two classes of problems: • How do all firms react to particular events? • Changes in input prices • Changes in output prices • Why are there different types of firms doing different things? • Partnerships, proprietorships, corporations, joint ventures, etc. • The two views complement each other

3. Basics of the neoclassical firm • The firm — headed by the entrepreneur — makes decisions • What to produce? • When and how to produce it? • How much to produce? • What is its price? • The firm has a production function • Relates inputs and outputs — a recipe, if you will • q = q (x,y,z) • q is output • x, y, z are inputs • The exact form depends on technology, state of knowledge, etc.

4. A production function • Here is a production function that is a mechanical view of production—labor, supplies and capital: • 1 shovel of cement • 3 shovels of sand • 5 shovels of stone • 1 gallon of water • Use labor and hoe to mix cement, sand, and stone for 1 minute • Add water • Use labor and hoe to mix for two minutes • Yield is three gallons of wet concrete

5. Basics of Property Rights Theory: Why do firms exist? • Neoclassical theory focuses on the mix of a variety of factors of production (“inputs”), called capital, labor, etc. • Property Rights theory asks if productivity of these factors should depend on whether we hire them out or use them ourselves—who owns what and what are the incentives? • We see a variety of choices in the real world • Some use theirs and theirs alone • Some rent out for use by others • Some do the renting

6. The firm vs. the market • The line between the market vs. command and control • The market relies on spot prices to provide information and induce decisions • The firm relies on command and control within the context of “long term” contracts to inform and induce • The tradeoff: • Market is informationally efficient • The firm is contractually efficient • The balance between these two determines the margin of choice between the firm and the market

7. What Kind of Organization? A key role of managers is to procure inputs in the least cost manner—including providing incentives for workers to be productive. If this is not accomplished, costs will be higher than needed and the firm will lose profits and perhaps go out of business in a competitive market.

8. Methods of Obtaining Inputs Three major methods: 1. Spot market or spot exchange— When buyers and sellers of inputs meet, exchange, but may not deal again. Benefit: this allows us to deal with specialized sellers, usually with low transaction costs. It means we do not have to integrate the seller into the firm. Possible problem: exploitation by seller who knows we are ignorant or need supply badly.

9. Methods of Obtaining Inputs Three major methods: 2. Contracts— Legally based extended relationship between buyer and seller. Benefits: specialization, ability to terminate sellers who do not perform, reduction in opportunistic behavior compared to spot markets. Problem: costly in complex environments.

10. Methods of Obtaining Inputs Three Major Methods: 3. Vertical Integration— When a firm chooses to produce an input internally rather than contract with outsiders. Benefits: reduced opportunistic behavior by outsiders and fewer contracting costs. Problems: lost specialization and increased organizational costs.

11. Methods of Obtaining Inputs Summary: Is there substantial specialized investments relative to contracting costs? If no—likely to use spot market. If yes—is the cost of contracting high relative to the cost of integration? If yes—vertical integration; if no—contracts with outside suppliers.

12. Major Drawback of Firms: Agency Costs The agency problem (and cost it imposes) arises from the problem of the separation of ownership and control. Owners of firms are interested in profit maximization. Managers and other employees are interested in maximizing own self-interests. How do we give managers an incentive to act as if they were owners of the firm? How do we get employees to not shirk—that is, work as hard as they can in the manner the owners would want.

13. Agency Costs • Who gets what — or thinks they deserve something — is often a part of what are classified as Agency Costs or Agency Problems. • Agency costs exist as a problem whenever a principal hires an agent to act on his behalf. • Solving these problems is a key managerial problem in managing personnel and in controlling costs.

14. Agency Costs . . . • These are a problem because we are human. If we “cheat” ourselves, then no one else bears the cost. So we never cheat ourselves (except after the fact — we may think so). • It is natural for us to want to exploit others — get others to pay more than they agreed to pay or produce less than we agreed to produce. A divergence in interest between principal and agent.

15. Monitoring, Signals and Contracts • Assume a company will need an average of 50 hours of legal work a year at $100/hour. • The law firm has an incentive to inflate the number of hours to maybe 70 hours. • Company knows that, so pays an expert to monitor the law firm • Law firm knows it is being monitored so has incentive to monitor itself. • Parties may reach fixed price contract to avoid monitoring costs & send right signal.

16. Monitoring • Because we have incentives to shirk – take more than we should or work less than we should – others have to monitor us. Monitoring is costly (which means it is sensible to accept some losses — pencils). • Usually there is unequal (asymmetric) information between two parties — one knows more than the other and can exploit that. • Ex.: Person selling used car. Lawyer doing legal work. Person choosing insurer (buyer exploits seller)

17. Monitoring & Bonding • How do we assure customers that we will not exploit them unfairly—that they will pay a reasonable, market price? Various devices: Fixed price contracts; Bonds; Warranties; Future price guarantees. Less formal: Reputation (evidence is strong that this matters in market)

18. 3 Levels of Monitoring Firms Markets discipline firms in three ways: • Internally: Poor performing firms usually fire top management. • Market for Corporate Control: Poor performers replaced by new owners who pay a premium to get assets. • Bankruptcy or other exit.

19. The entrepreneur • What determines who is giving the orders and who is receiving? • Suppose there is some factor called entrepreneurial capacity (or entrepreneurial ability) • Possessed by each of us • NOT marketable (and so has no opportunity cost) • The returns to this factor vary among people and so determine whether they bother to use it or not

20. The entrepreneur’s reward • Capital and labor are paid contractually—by the hour, or the output, or whatever • Entrepreneur receives a residual payment on a noncontractual basis • Payment for monitoring (“managing”) K & L • If done well (or just guesses right) the payment is positive; if not, payment is negative • Profit is difference between revenues and costs • The factor E has no opportunity cost • Thus profit is the payment E • Profit is reward for making costs lower than other firms’ profits

21. Entrepreneurs and their Firms • Key Managerial Problem: Giving employees incentives to act as if they are owners. In general: Decentralization of Authority required and movement has been in this direction; especially in knowledge-based production.

22. Decentralization: Pros & Cons • Empowering workers and managers is a good concept-- BENEFITS: 1. More effective use of local knowledge — those closest know the most – quick decisions 2. Conservation of time of senior management — important people cannot know or do everything 3. Training & motivation for local managers — helps attract and keep good managers and train future top managers

23. Decentralization . . . A good idea but obviously not perfect-- COSTS: 1. Agency costs— shirking; self-dealing—so control and monitoring measures needed 2. Coordination costs and failures— duplication; pricing errors 3. Less effective use of central information— local managers cannot know all information held by the central managers, so have inferior knowledge

24. Decentralizing: Team Decisions • Create teams composed of people with different area expertise empowered to make decisions— Ex.—Hallmark Cards has teams of art, design, production and marketing assigned by holiday with decision rights rather than move produce from functional area to area—cut time in half. Benefits—Improved use of dispersed specific knowledge and employee “buy in” due to better information, more cooperation & less blame. Costs—Collective-action problems and free-rider problems.

25. Decision Management & Control 1. Initiation—proposals to use firm resources and the structuring of contracts 2. Ratification—choice of initiatives to be implemented 3. Implementation—execution of ratified decisions 4. Monitoring—measurement of performance of decision agents and implementing rewards Remember — agents (managers within a firm) do not bear the full cost of their actions, so cannot be delegated both decision management and control — hierarchy still necessary. Make authority and lines of control clear to avoid confusion.

26. Questions on the Firm • If firms profit maximize, as economic theory predicts, then in a highly competitive industry will there be much discrimination against minorities or women?

27. How Do We Overcome Agency Costs? • The larger the organization, or the greater the distance from the owners to the workers, the more likely that agency costs will become significant —large corporation look more like an inefficient government agency. What economic incentives do firms take to try to give workers proper incentives?

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

29. Question on Team Incentives • Suppose different numbers of people are assigned to pull a rope “as hard as you can.” • One person pulls the rope. • Three people pull the rope together. • Eight people pull the rope together. • How does the pulling force (work effort) per person change across these three cases?

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

31. Is Decentralization the Key? • There has been much discussion of the problems of centralized control and the benefits of a decentralized organization • These are some benefits of decentralized decision making: 1. More effective use of local knowledge 2. Conservation of time of senior managers 3. Motivation for local managers What are the costs imposed by these same benefits?

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