© 2009 Pearson Education Canada 19/1 Chapter 19 The Theory of the Firm

© 2009 Pearson Education Canada 19/2 Who Owns the Firm?  Ownership means essentially 3 things: 1. Control of decisions within the firm. 2. Residual claims on the firm. 3. The right to sell the rights to the above.

© 2009 Pearson Education Canada 19/3 Control of Decisions Within the Firm  Control includes deciding what products to make, how to produce them, how to sell them and what prices to adopt.

© 2009 Pearson Education Canada 19/4 Residual Claims on the Firm.  A residual claimant has the right to take home income from profits (revenues less costs).  Within a firm there may be many types of claimants (stock holders, employees with bonuses, etc.).

© 2009 Pearson Education Canada 19/5 The Right to Sell Ownership and Residual Claims. The Right to Sell Ownership and Residual Claims.  Ownership involves the right to transfer the assets of the firm.  Stockholders may have the right to hire and fire a CEO, but not the right to negotiate capital purchases.

© 2009 Pearson Education Canada 19/6 Figure 19.1 The pattern of ownership

© 2009 Pearson Education Canada 19/7 Three Relationships Between Residual Claimants and Control of the Firm 1.Owner-operated -The person who makes the managerial decisions that affect the firm’s profits is the same as the person who lays claim to that profit. 2.Partnership -The ownership and management functions are jointly shared by two or more persons who work in the firm.

© 2009 Pearson Education Canada 19/8 Three Relationships Between Residual Claimants and Control of the Firm 3.Corporation - where residual claimancy is almost totally separate from management or control. For example in publicly held corporations residual claimancy is spread over the share holders and at the same time executives exercise control within the firm.

© 2009 Pearson Education Canada 19/9 Organizational Forms  The central hypothesis of the modern theory of the firm is that the organizational forms that we encounter every day are the ones that achieve the closest possible identity between the objectives of the individuals inside the firm and those of the firm as a whole.

© 2009 Pearson Education Canada 19/10 The Owner-Operator Firm  For simplicity, it is assumed that each unit of effort generates $1 of income. (y R =e R ).  At the equilibrium of the one–person firm, the slope of the indifference curve (MRS=the rate at which additional effort generates additional income) is equal to 1. (see Figure 19.2)

© 2009 Pearson Education Canada 19/11 Figure 19.2 Preferences over effort and income

© 2009 Pearson Education Canada 19/12 Figure 19.3 The one-person firm

© 2009 Pearson Education Canada 19/13 A Partnership Alternative  For the two person firm, the sum of their incomes must equal the effort they jointly expend: y R +y V =e R +e V.  One partner’s income is determined by the following income effort relationship: y R =(e R +e V )/2.  The partnership fails to create the optimal private incentive because neither partner can capture the whole added output from increasing his/her personal effort.

© 2009 Pearson Education Canada 19/14 Figure 19.4 Shirking in a partnership

© 2009 Pearson Education Canada 19/15 Figure 19.5 The partnership equilibrium

© 2009 Pearson Education Canada 19/16 Pareto-Optimality and the Choice of Institutions  Modern theories of the firm suppose that a Pareto-optimal organizational form will be chosen.  An organizational form is Pareto-optimal if there is no other organizational form that will leave all parties at least as well off and at least one party better off.

© 2009 Pearson Education Canada 19/17 Team Production  Team production is an arrangement in which two or more workers accomplish a productive task through joint effort.  When the productivity gains associated with joint product (B) are large enough, the partnership is preferred to one–person firm.

© 2009 Pearson Education Canada 19/18 Figure 19.6 The owner-operated firm

© 2009 Pearson Education Canada 19/19 Owner-Operated Firm  In absence of contracting or monitoring costs, the owner-operated team is Pareto-preferred to both the one-person firm and the partnership.  This notion is illustrated by comparing equilibriums C and D in Figure 19.6.

© 2009 Pearson Education Canada 19/20 Contracting and Monitoring Costs  Our model will now be extended to include costs of entering into contracts with employees and monitoring employee productivity.  Roberta must pay for half the monitoring costs (M) but can keep all income generated from her effort.  Her income-effort relationship is: y R =Be R -M/2

© 2009 Pearson Education Canada 19/21 Figure 19.7 The owner-operated firm with monitoring costs

© 2009 Pearson Education Canada 19/22 Contracting and Monitoring Costs  Given the income–effort relationship, Roberta can attain point V in Figure  The following contract will allow Roberta & Victor to attain point V: –Victor will receive income Y’ from Roberta if he supplies e’ or more units of effort. –However, if he supplies less than e’ units of effort, he will receive no income.

© 2009 Pearson Education Canada 19/23 Pareto-Optimal Organizational Forms:  Depending upon the productivity advantage associated with team- work (B) and the costs of monitoring (M), any one of the three organizational forms considered can be Pareto-optimal relative to the others.

© 2009 Pearson Education Canada 19/24 Figure 19.8 Pareto-preferred organizational forms

© 2009 Pearson Education Canada 19/25 Specialization and the Division of Labour  According to Adam Smith (1776), three factors explain increased productivity from specialization and division of labour: 1. Specialized workers are more productive via repetition (learning by doing). 2. Workers save time by not switching tasks. 3. Specialization encourages technical progress.

© 2009 Pearson Education Canada 19/26 Transaction Costs  A firm will expand to the point at which the cost (including transaction cost) of adding another function in- house is just equal to the cost (including transportation costs) of coordinating that function through the marketplace.

© 2009 Pearson Education Canada 19/27 Generic Versus Specific Inputs  On one hand, firms have the incentive to buy generic inputs, because they can thereby avoid the difficulties associated with harmonizing the interests of individuals within the firm.

© 2009 Pearson Education Canada 19/28 Generic Versus Specific Inputs  On the other hand, firms have a disincentive to buy specific inputs from other firms because these inputs are subject to high transaction costs across markets.

© 2009 Pearson Education Canada 19/29 Generic Versus Specific Inputs  Whether we find decentralization (coordination of economic activity via markets) or centralization (coordination of economic activity within firms) depends upon whether the advantages of decentralization outweigh the resulting contracting costs.