Lecture 11 Economic Theory of the Firm There are two views 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 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 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

Traditional Theory of the Firm Traditionally, the firm — headed by the entrepreneur or manager — makes decisions: 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: The firm is seen as having a production function: –Relates inputs and outputs — like a recipe q = q (x,y,z) q = q (x,y,z) q is output q is output x, y, z are inputs x, y, z are inputs –The exact form depends on technology, state of knowledge, etc.

A production function A production function is often a mechanical or engineering view of production—labor, supplies and capital: A production function is often a mechanical or engineering view of production—labor, 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.

Property Rights Theory: Firms and Markets Where is the line between the market vs. command and control (within the firm)? 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: 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 The balance between these two determines the margin of choice between the firm and the market

What Kind of Organizational Form to Choose? 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. Does a manager procure inputs from the market or procure inputs within the firm?

How to obtain needed inputs? Consider possible stages of production: Obtaining raw materials Obtaining finished parts Assembly Transportation services StorageWholesalingRetailing

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?

Who provides such needed services and functions? Should the firm produce within the organization or outsource? Should the firm produce within the organization or outsource? There is no one answer—many conditions will determine outcome. There is no one answer—many conditions will determine outcome. Think of the great range of options: Think of the great range of options: Spot markets → Long Term Contracts → Vertical Integration (produce in house)

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.

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.

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

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.

When Is Vertical Integration Most Likely to Be Necessary? Brand name (goodwill) protection Brand name (goodwill) protection When there are specific assets When there are specific assets When there are high sunk costs When there are high sunk costs When contracts especially difficult to enforce When contracts especially difficult to enforce

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.

Recent Example: Ford Ford had used annual bidding competition to achieve low cost suppliers for auto parts ($70 billion a year). 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 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. Solution: longer term contracts with fewer suppliers (down from 2,500 to 1,000); closer working relationship; estimated savings of 10% per year.

Agency Costs Who gets what — or thinks they deserve something — is a part of what we call Agency Costs or Agency Problems. 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. 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. Solving this universal problems is a key managerial problem in managing personnel and in controlling costs.

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 shirk—that is, work as hard as they can in the manner the owners would want? Telling people to work hard does not help much—it is a matter of incentives.

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. 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. 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.

Monitoring, Signals and Contracts Assume a company will need an average of 50 hours of legal work a year at $100/hour. 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. 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 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. Law firm knows it is being monitored so has incentive to monitor itself. How to avoid this problem both parties recognize? How to avoid this problem both parties recognize? Parties may reach fixed price contract to avoid monitoring costs & send right signal. Parties may reach fixed price contract to avoid monitoring costs & send right signal.

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)

Monitoring & Bonding How do we assure customers that we will not exploit them unfairly—that they will pay a reasonable, market price? 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. The evidence is strong this matters greatly in the market. We pay premiums to deal with firms with good reputations.

Entrepreneurs and their Firms Key Managerial Problem: 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.

Decentralization: Pros & Cons Empowering workers and managers is a good concept-- 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

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

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 area—cut time in half. Benefits—Improved use of specific knowledge and employee “buy in” due to better information, more cooperation & less blame. Costs—Collective-action and free-rider problems. Same thing in car production—team development tried at Chrysler; separate functional areas at GM. Tradeoffs.

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.

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? 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?

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? 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?

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

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? 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?