Lecture 11 Economic Theory of the Firm

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Lecture 11Economic Theory of the Firm

• There are two views of the firm
• 1. Neoclassical (traditional) theory
• Firm is a calculating entity, that makes
  decisions, buys inputs, making output, and
  selling for profit for loss
• 2. 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

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Traditional Theory of the Firm

• Traditionally, the firm headed by the
  entrepreneur or manager makes decisions
• What to produce?
• When and how to produce it?
• How much to produce?
• What is its price?
• The firm is seen as having a production function
• Relates inputs and outputs like a recipe
• q q (x,y,z)
• q is output
• x, y, z are inputs
• The exact form depends on technology, state of
  knowledge, etc.

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A production function

• A production function is often a mechanical or
  engineering view of productionlabor, supplies
  and capital
• 1 shovel of cement
• 3 shovels of sand
• 5 shovels of stone
• 4 liters of water
• Use labor to mix cement, sand, and stone for 1
  minute
• Add more water to get right texture
• Use labor and hoe to mix for 2 minutes
• Output 12 liters of wet concrete
• Most of this is engineering. The role of
  economics is limited to the importance of price,
  substitutes, etc. Important concepts, but not
  difficult to grasp.

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Property Rights Theory Firms and Markets

• Where is the line between the market vs. command
  and control (within the firm)?
• 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

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What Kind of Organizational Form to Choose?

• A key role of managers is to procure inputs in
  the least cost mannerincluding 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.
• Does a manager procure inputs from the market or
  procure inputs within the firm?

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How to obtain needed inputs?

• Consider possible stages of production
• Obtaining raw materials
• Obtaining finished parts
• Assembly
• Transportation services
• Storage
• Wholesaling
• Retailing

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How to obtain needed inputs?

• Consider general services needed by an
  organization
• Accounting
• Finance (including credit service)
• Human Resources
• Legal Services
• Marketing (advertising, etc.)
• Janitorial Service
• Who is to provide such services?

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Who provides such needed services and functions?

• Should the firm produce within the organization
  or outsource?
• There is no one answermany conditions will
  determine outcome.
• Think of the great range of options
• Spot markets ? Long Term Contracts ?
• Vertical Integration (produce in house)

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Methods of Obtaining Inputs

• 1. Spot market or spot exchange
• Buyers and sellers of inputs exchange, but might
  not deal again. Benefit deal with specialized
  sellers, usually with low transaction costs. It
  means we do not have to integrate the seller into
  the firm or deal with over time. Possible
  problem exploitation by seller who knows we are
  ignorant or need supply badly.

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Methods of Obtaining Inputs

• 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.
  Problems costly in complex environments
  incentives to cheat act badly.

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Many Forms of Contracts

• Services (Deere and Ryder Trucks UPS and
  Toshiba warranty laptop repairs UPS and Jockey
  Japanese call centers in Dalien)
• Joint Ventures (foreign firms in China)
• Leases (office buildings)
• Franchises (McDonalds, car dealers)
• Strategic Alliances (Merck Astra)

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Methods of Obtaining Inputs

• 3. Vertical Integration
• (Non-market exchange)
• 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.

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When Is Vertical Integration Most Likely to Be
Necessary?

• Brand name (goodwill) protection
• When there are specific assets
• When there are high sunk costs
• When contracts especially difficult to enforce

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Methods of Obtaining Inputs

• Summary
• Is there substantial specialized investments
  relative to contracting costs? If nolikely to
  use spot market.
• If yesis the cost of contracting high relative
  to the cost of integration? If yesvertical
  integration if nocontracts with outside
  suppliers.

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Recent Example Ford

• Ford had used annual bidding competition to
  achieve low cost suppliers for auto parts (70
  billion a year).
• Problems high administrative cost, bankruptcy by
  suppliers, quality control uneven
• Solution longer term contracts with fewer
  suppliers (down from 2,500 to 1,000) closer
  working relationship estimated savings of 10
  per year.

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Agency Costs

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

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A Major Drawback of Firms Agency Costs

• The agency problem arises from 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 shirkthat is, work as hard as
  they can in the manner the owners would want?
  Telling people to work hard does not help muchit
  is a matter of incentives.

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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. So the
  one-person firm is efficient and does not suffer
  agency costs.
• It is natural for us to want to exploit others
  get others to pay more than they agreed to pay or
  we produce less than we agreed to produce. That
  is, a divergence in interest between principal
  and agent in a multi-person organization and in
  contracts.

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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.
• How to avoid this problem both parties recognize?
• Parties may reach fixed price contract to avoid
  monitoring costs send right signal.

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Monitoring

• We have incentives to shirk take more than we
  should or work less than we should. Monitoring is
  costly, so sensible to accept some losses. Many
  forms of monitoring (spot checks, etc.).
• Usually there is unequal (asymmetric) information
  between parties. One knows more than the other
  and can exploit that.
• Examples. Person selling used car.
• Buy insurance (buyer exploits seller)

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Monitoring Bonding

• How do we assure customers that we will not
  exploit them unfairlythat they will pay a
  reasonable, market price?
• Various devices
• Fixed price contracts Bonds Warranties
• Future price guarantees.
• Less formal Reputation. The evidence is strong
  this matters greatly in the market. We pay
  premiums to deal with firms with good reputations.

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Entrepreneurs and their Firms

• Key Managerial Problem
• Giving employees incentives to act as if they are
  owners.
• In general The entrepreneur or top manager must
  cede authority to others. The movement has been
  in this direction especially in knowledge-based
  production.

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Decentralization Pros Cons

• Empowering workers and managers is a good
  concept--
• BENEFITS
• 1. More effective use of local knowledge
• those closest know the most
• 2. Conservation of senior management top
  people cannot know or do everything
• 3. Training motivation for local managers
  helps attract and keep good managers and train
  future top managers

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Decentralization . . .

• A good idea but obviously not perfect--
• There Are 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 the
  central managers, so have inferior knowledge

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Decentralizing Team Decisions

• Create teams composed of people with different
  expertise 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 areacut time in half.
• BenefitsImproved use of specific knowledge and
  employee buy in due to better information, more
  cooperation less blame.
• CostsCollective-action and free-rider problems.
• Same thing in car productionteam development
  tried at Chrysler separate functional areas at
  GM. Tradeoffs.

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Decision Management Control

• 1. Initiationproposals to use firm resources and
  the structuring of contracts
• 2. Ratificationchoice of initiatives to be
  implemented
• 3. Implementationexecution of ratified decisions
• 4. Monitoringmeasurement 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.

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Questions 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?

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Question 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?

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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?

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Incentives of Managers

• In the fast-food industry, about 30 of stores
  are company owned and run by a salaried 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) Why then does the parent choose to own some?
  Where would they be located?
• 3) Would you expect employees to see a
  difference in the managers?