1. The Firm: Owners, Managers & Employees
Lecture 3
Unit 6 -

2. Reading Unit 6: The Firm: Managers, Owners & Employees
Sections

3. OUTLINE Introduction Firms Labour Contracts and Employment Rents
Labour Discipline Model

4. Learning Objectives
How the interactions among the firm’s owners, managers and employees influence wages, work, and profits, and how this affects the workings of the entire economy
The firm is an actor in the capitalist economy, and a stage on which interactions among the firm’s employees, managers and owners are played out
The balance of bargaining power among employees, managers and owners affects how the mutual gains created in the firm are distribute
Hiring labour is different from buying other goods and services, and the contract between the employer and the employee does not cover what the employer really cares about: how hard and well the employee works
Firms do not pay the lowest wages possible. Instead they set wages to motivate employees to work effectively, to stay with the firm, and to make it practical for the firms to recruit new workers when they need them
The wage curve shows the relationship between wages and unemployment in the economy as a whole

5. A. Introduction

6. Firms vs Markets In this lecture we study firms.
In the lectures that follow we study markets.

7. Worksheet Question
What are the differences between firms and markets?

8. B. Firms

9. Firms vs Markets
The firm differs in an important respect from markets:
Markets involve a decentralisation of power.
Firms represent a concentration of economic power in the hands of the owners and managers.

10. Firms Firm = a business organisation which
Employs people (owners can direct the activities of workers)
Purchases inputs to produce market goods and services
Sets prices greater than the cost of production

11. Firms
Apple, Samsung, American Apparel and Toshiba are business organisations called firms.
Not everyone is employed in a firm. For example, many farmers, carpenters, software developers or personal trainers work independently, as neither employee nor employer.
Others work for governments and not-for-profit organisations;
The majority of people in rich nations make their living by working in a firm.

12. Structure of a firm
Separation of ownership (shareholders) and control (managers)
Owners and managers have power over workers
Contracts specify a set of actions that the parties involved
should undertake

13. Worksheet Question
Draw a diagram that shows the structure of the firm for a family farm or small business that hires workers.

14. C. Nature of Labour & Employment Contracts

15. Wage Labour vs Goods Contract
Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and during those times to accept the authority of the employer over the use of his or her time.
Contracts for goods sold in markets transfer ownership of the good from the seller to the buyer.
Contracts for labour grant authority to direct the activities of the firm's employee from the employee to the manager or owner.

16. Labour Contracts are Incomplete
When the firm writes a contract for the employment of a worker, it cannot know exactly what it will need the employee to do, because this will be determined by necessarily unforeseen future events.
It would be impractical or too costly for the firm to observe exactly how much effort each employee puts in to the job.
Even if the firm somehow acquired this information, it could not be the basis of an enforceable contract.

17. Wage Labour Contract
Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and during those times to accept the authority of the employer over the use of his or her time. We might say that the employer has rented the employee for part of the day.
Contracts for labour grant authority to direct the activities of the firm's employee from the employee to the manager or owner.

18. The Problem of Incomplete Contracts
Incomplete contracts do not specify, in an enforceable way, every aspect of the exchange that affects the parties involved
If firms can’t directly measure effort, why do workers work hard?

19. Why do People Work Hard?
Given that employment contracts are incomplete & effort difficult to measure, why do people work hard?
Intrinsic motivation to do a good job
Reciprocate a feeling of gratitude to the employer for providing a good job
Owners’ right to fire: The owners of the firm, by definition, have the right to exclude the worker—that is, to terminate employment.
Employment rents: Rents make this a meaningful threat. Employees are typically paid much more than the minimum they would accept for taking the job, so they are receiving an economic rent (called an employment rent), meaning that they would prefer to keep the job rather than ending up with the reservation option.

20. Worksheet Questions
What would you include in an employment contract for a university lecturer that outlines the effort supplied so that teachers provide quality teaching to their students?
How would you monitor this contract?
Why might lecturers work hard to be a good teacher given that effort is difficult to define and monitor?

21. D. Determinants of Employment Rents

22. Employment Rents
Employees are paid more than their reservation option (receiving employment rents) so prefer to be employed.
Employment rent = cost of job loss, which includes
Lost income while searching for a job
Loss of firm specific assets such as the psychological costs of losing workplace friends
Costs required to start a new job e.g. relocation
Loss of non-wage benefits e.g. medical insurance, superannuation benefits (depends on country)
Social costs (stigma of being unemployed) & disutility of unemployment

23. Employment Rents & Power
Because owners and managers decide whether an employee stays or goes, they can benefit from the implicit threat of the sack to make the worker perform in ways that that person would not choose unless the threat was real.
This means that the owners and managers exert power over employees 

24. Size of Employment Rent
To understand what determines the size of the employment rent, we do not compare the worker with someone who is out of work, but with the person themselves if she were to lose her job.
So, to calculate Maria’s employment rent we need to compare what she is getting on the job with what she would get were she to lose the job:

25. Maria’s Hourly Net Benefit of Work = Wage/hour – Disutility of Effort/hour

26. Worksheet Questions
1. Refer to the diagram above a) Maria earns $12/hour and has an hourly disutility of effort at $2. Calculate her hourly employment rent

27. Maria loses her job for 44 weeks (No Unemployment Benefit)

28. Worksheet Questions
1. Refer to the diagram above b) If Maria loses her job it will take 44 weeks before she gets another job with the same pay. Calculate her total employment rent.

29. Maria’s employment rent for a given effort and $12 wage in an economy without an unemployment benefit
= What Maria gets should she not lose her job today
= What Maria gets should she lose her job today
Hourly wage = $ 12
Maria’s rent when employed
Employment rent per hour
Disutility of an hour of effort = $2
Disutility of effort when employed
Expected duration of unemployment = 44 weeks (1540 hours)
Number of 35-hour weeks

30. Worksheet Questions
1. Refer to the diagram above c) Let’s now assume that the employer decides to get Maria to do extra tasks at work, which she really dislikes doing. This increases her hourly disutility of work to $4. Calculate her total employment rent. d) Illustrate the change in utility on the employment rent diagram

31. with an unemployment benefit of $6/hour
Maria’s employment rent for a given effort and a $12 wage in an economy
with an unemployment benefit of $6/hour
= What Maria gets should she not lose her job today
= What Maria gets should she lose her job today
Hourly wage = $ 12
Maria’s rent when employed
Employment rent per hour
Unemployment benefit plus the disutility of effort = $8
Disutility of effort when employed
Unemployment benefit = $6
Reservation wage per hour
What Maria receives in unemployment benefit during her period of unemployment
Expected duration of unemployment = 44 weeks
(1540 hours)
Number of 35-hour weeks

32. Worksheet Questions
Assume now that Maria were to receive an unemployment benefit (or some other payment from part-time work, family etc.) = $6/hour if she lost her job.
a) Calculate her hourly employment rent.
b) Calculate Maria’s total employment rent.
c) What is the impact of unemployment benefits on employment rent?

33. Calculating Employment Rents
Reservation wage = value of
next best option
Employment rent =
wage
– reservation wage
– disutility of effort

34. E. Labour Discipline Model

35. Labour Discipline Model: Employee’s Best Response Curve = Firm’s Feasible Frontier

36. Employee’s Best Response
Employee’s Best Response = relationship between effort and wages.
Effort per hour, measured on the vertical axis, varies between zero and one.
We can think of this as the proportion of each hour that Maria spends working diligently (the rest of the time she is not working). For example, an effort level of 0.5 indicates Maria is spending half the day on non-work related activities such as checking Facebook, shopping online, or just staring out of the window.

37. Best effort provided by employee for each wage rate

38. Worksheet Questions
1. Show on the employees best response curve, when the reservation wage/hour = $6, the actual wage/hour = $12/hour, which elicits and effort level of 0.5.
2. What does this tell us about the amount of work the employee does when the hourly wage = $12?

39. The Impact on Effort as Wages Increases

40. Worksheet Question
3. What happens to effort as wages increase?

41. Employee’s best effort responses to different wages = feasible set of effort (production) for the employer for different wage rates

42. Worksheet Questions
What does the Marginal Rate of Transformation (MRT) represent in the best response curve?
What is the trade-off that employers face with the best response curve?
What would employees do if the employer paid her employees the reservation wage?

43. Provides information about wages & output
Maria's best response curve shows how a cost to the employer (higher wages) translates into something the employer values: more effort, and therefore more output, from his workers
The best response curve is therefore the frontier of the employer’s feasible set of combinations of wages and effort that it gets from its employees. 

44. Best Response Curve
Maximum possible effort
Best response curve shows the optimal amount of effort workers will exert for each wage offered
Represents the firm’s feasible frontier for wages and effort
Slope of best response curve = MRT

45. Labour Discipline Model: Isoprofit Lines

46. Isoprofit Lines
A line like the one shown in the following diagram has a slope of e/w.
We call this line an isoprofit line because, holding constant the other influences on profits, the employer’s profits per unit of output produced are the same for every point on the curve.

47. Isoprofit Lines

48. Drawing the Isoprofit Line
Firms maximise profits by minimising production costs
(costs of effort + other inputs)
Isoprofit curve = all combinations of inputs that give the same profit
Slope of isoprofit curve = MRS = e/w

49. Labour Discipline Model: Determining Wages

50. Determining wages
Firms choose the point on the best response curve that gives the highest profit possible
MRS = MRT
Efficiency wage = wages set higher than the reservation wage so workers will provide more effort

51. What has the labour discipline model told us?
Equilibrium: In the owner-employee game, the employer offers a wage and the employee provides a level of effort in response.
Rent: In this allocation the employee provides effort because she receives an employment rent that she might lose were she to slack off on the job.
Power: Because the employee fears losing the rent, the employer is able to exercise power over her, getting her to act in ways that she would not do in the absence of the threat of job loss. This contributes to the profits of the employer.
Involuntary unemployment: The fact that employees are receiving a rent means that were she to lose her job, she would be worse off. She could only not be worse off if she could get re-employed immediately at the same wage. She would therefore be involuntarily unemployed. Just as she prefers to keep her job rather than being unemployed, there are other people who would prefer to have her job rather than remaining unemployed; so there is unemployment in the equilibrium of the game.

52. Position of the Best Response Curve
The importance to the employee of the things that can be bought with the wage
How unpleasant it is to exert effort
The probability of getting fired when working at each effort level
The worker’s reservation wage (size of unemployment benefits & access to assistance when unemployed)

53. Implications of the Model
Involuntary unemployment since workers are paid above their reservation wage
Policies can shift the entire best response function by changing e.g.
the reservation wage
economic rents of employment

54. Worksheet Questions
What impact does an increase in the unemployment rate have on the amount of effort supplied at each wage rate? What happens to the employment rent?
What impact does a decrease in unemployment benefits have on the amount of effort supplied at each wage rate?
Illustrate the impact on the best response curve.
Illustrate the impacts on the equilibrium hourly wage rate and profits for the firm. (Put the isoprofit and employee’s best response on the same diagram)

55. F. The Firm & Its Employees in the Economy

56. Wage Curve
We can now broaden the perspective from a single firm to the economy as a whole.
We ask how changes in the unemployment rate affect the wage set by employers.
The wage curve is the profit maximising wage at different levels of unemployment

57. Wage Curve: Labour Force = Unemployment Rate + Employment Rate

58. Worksheet Questions
Assume that the unemployment rate increases from 5% to 12%.
What happens to the employees’ best response curve?
Illustrate on the diagram using employee’s best response curve and the isoprofit line.
What happens to the hourly wage rate paid to employees and the profit of employers?

59. Wage Curve: Illustrate the Relationship between hourly wages & unemployment (5% & 12%)

60. The Wage Curve
The wage curve shows the economy-wide real wage required for sufficient worker effort, for each given employment rate
Represents aggregate effects
of wage-setting interactions
between workers and firms

61. Wage Curve for the USA (1979-2013)

62. Policies can affect the wage curve
Raising unemployment benefits
-> Raises reservation wage
-> Shifts best response function to the right
-> Lowers firm’s profits
-> Shifts wage curve up

63. Worksheet Questions
Illustrate the impact of increasing unemployment benefits when the unemployment rate = 10%
a) Isoprofit & employee’s best response diagram
b) Wage curve diagram

64. Fairness and reciprocity
Workers adjust effort according to the fairness of their working conditions
Workers receive higher disutility when conditions are ‘unfair’, and reciprocate by lowering effort (flattening their
best response curve).

65. Summary Firms: owners and managers have power over workers
Contracts are incomplete
Employment rents motivate workers to exert effort
2. Labour-discipline model of wage-setting
Isoprofit curves = firm’s ‘indifference curves’
Best response curve = maximum feasible effort, given wages
Profit-maximising choice where MRS = MRT
3. Wage curve = economy-wide result of firm-worker interactions
Policies can affect the wage-setting process