EA Session 5: July 11th, 2007 Prof. Samar K. Datta Firm & Production EA Session 5: July 11th, 2007 Prof. Samar K. Datta

Overview Why does a firm exist? Internal organization of the firm Decision to buy (subcontracting) or to make (internalization/ integration) Internal organization of the firm Handling separation between ownership and control Technology & production function Classification of inputs & isoquants Production with one variable input (labor): Relation between AP & MP Production with two variable inputs & diminishing MRTS Returns to scale Some applications

Why does a firm exist? (not part of reading though) Answers provided by various economists Coase (highlighting inside vs. market transaction) Choice of the least transaction-cost contractual arrangement to supply the commodity Negotiating with a representative of a coalition of resource owners (firm) for the complete commodity Negotiating with a large number of unitary firms for each component and assemblage of the commodity Alchian & Demsetz (shirking under team production) Impossible to measure marginal product of each member of the team Creates incentive to shirk (reduce work effort without proportional reduction in income) To prevent shirking, members hire central agent to monitor themselves Monitor has low incentive to shirk as he gets a claim on the firm’s residual income

Why does a firm exist? (not part of reading though) Barzel (highlighting measurability problem) Environment characterized by costly information and outcomes affected by chance Due to decreasing returns from supervision, the one whose contribution to common effort is the most difficult to measure will assume the role of entrepreneur Asymmetric information about entrepreneurial activity gives strategic advantage to entrepreneur Measurement problem solved by assigning entrepreneur a claim on the residual value of the joint venture. Williamson (highlighting role of specialized assets to conduct transactions – need to vest residual control and residual claim right on a single party) A specialized or custom-made product has asset specificity, which is vulnerable to opportunistic behavior by both buyers and sellers Ownership of specialized products or detailed long-term contracts are used to prevent problems of opportunistic bargaining Formalized structure of a firm is the specialized asset in this case Therefore, the least transaction cost alternative is chosen

Why are capitalists the bosses? Who has got the maximum stake in the production process/system? With respect to whose efforts is there the maximum information failure problem? Which factor of production is a co-specialized asset along with the firm – land, labor, capital or the capitalist-entrepreneur?

Why does a firm exist? Two broad conditions, as cited by Dholakia & Oza: Q (x, y) ≥ Q (x) + Q (y), or, C (x, y) ≤ C (x) + C (y) 2. TC (x, y) ≤ TC (x) + TC (y) Economies of scope thus working in terms of saving in Either transformation costs (i.e., costs of inputs, which enter directly into the production process) Or transaction costs (i.e., costs of coordination & monitoring of inputs directly entering into the production process)

Internal organization of the firm Unitary, partnership, or corporation M (multi-divisional) form or U (unitary) form How to manage separation between ownership and control Incentive-disincentive structure Market for managers Market for takeover Financing of the firm – debt/equity Growth of the firm Organic (till marginal benefits, i.e. reduction in transaction costs, of internalizing an additional activity equal the marginal costs, i.e. increase of agency costs) Inorganic Merger / Acquisition Vertical merger (value-addition through byproduct use) Horizontal merger (economies of scope through co-management of related products)

Possible objectives of the firm Profit maximization Sales maximization Growth maximization Employment generation Satisficing behavior In the long-run, no firm can ignore profit considerations. Hence, profit maximization often looked upon as a reasonable description of firm behavior in reality.

The technology of production Production Process: Combining inputs or factors of production (land, labor, capital, organizational skill) to achieve an output, i.e., the transformation process Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs, given the state of technology. Shows what is technically feasible when the firm operates efficiently.

The Isoquant Map: Production with Two Variable Inputs (L,K) Capital per year E 5 Isoquants showing all possible combinations of inputs that yield the same output 4 3 A B C 2 Q3 = 90 D Q2 = 75 1 Q1 = 55 1 2 3 4 5 Labor per year 14

Importance of time period Short-run: Period of time in which quantities of one or more production factors cannot be changed. These inputs are called fixed inputs. Long-run: All inputs are variable in the long run; so there are no fixed inputs. 16

Production with One Variable Input (Labor): Relation between AP & MP AP = slope of line from origin to a point on TP, lines b, & c. MP = slope of a tangent to any point on the TP line, lines a & c. Output per Month Output per Month D 112 30 C E 20 60 B 10 A Labor per Month Labor per Month 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 23

Law of Diminishing Marginal Returns When the labor input is small, MP increases due to specialization (better utilization of fixed inputs). When the labor input is large, MP decreases due to inefficiencies (fixed factors become limited in supply). 32

Effect of Technological Improvement Output per time period O2 B Labor productivity can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor. C O3 100 A O1 50 Labor per time period 1 2 3 4 5 6 7 8 9 10 37

Marginal Rate of Technical Substitution Q1 =55 Q2 =75 Q3 =90 Capital per year 5 1 2 2/3 1/3 Isoquants are downward sloping and convex like indifference curves, indicating declining MRS. 4 3 2 1 1 2 3 4 5 Labor per month 60

Isoquants When Inputs are Perfectly Substitutable Capital per month Q1 Q2 Q3 A B C Labor per month 64

Fixed-Proportions Production Function: Inputs are perfect complements K1 Q1 Q2 Q3 A B C Capital per month Labor per month 66

Increasing Returns to Scale The isoquants move closer together 5 10 2 4 A Capital (machine hours) 10 20 30 Reasons: Larger output associated with lower cost (autos) One firm is more efficient than many (utilities) Labor (hours) 75

Constant Returns to Scale 10 20 30 Capital (machine hours) 15 5 10 2 4 A 6 Constant Returns: Isoquants are equally spaced because: Size does not affect productivity May have a large number of producers Labor (hours) 75

Decreasing Returns to Scale Capital (machine hours) 5 10 2 4 A 10 20 30 Decreasing Returns: Isoquants get further apart due to: Decreasing efficiency with large size Reduction of entrepreneurial abilities Labor (hours) 75

Application: Malthus and the Food Crisis Why did Malthus’ prediction fail? Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand. Technology has created surpluses and driven the price down. Question: If food surpluses exist, why is there hunger? The cost of distributing food from productive regions to unproductive regions and the low income levels of the non-productive regions. 40

Example: Explanations for Productivity Growth Slowdown 1) Growth in the stock of capital (both human and non-human) is the primary determinant of the growth in productivity. Rate of capital accumulation in the U.S. was slower than other developed countries because the others were rebuilding after WWII. 3) Depletion of natural resources 4) Environmental regulations 45

Co-existence of large & small units in the carpet industry Economies of scale seem to be favoring larger units Advantages of product diversification as supported by market segmentation favoring smaller units