1. 1 Coase, Theory of the Firm, Tirole chapter 0 Eric Rasmusen, erasmuse@Indiana.edu erasmuse@Indiana.edu G604, Tirole-Coasle, size of firms, 14 November, 2006 I decided it is better to teach mostly with the whiteboard, not slides, so these are now just my notes and a few things like the Coase quotes that I project up.

2. 2 Classics: Organization R. H. Coase (1937) "The Nature of the Firm," Economica, New Series, 4, 16: 386- 405 (November 1937) Classics: Organization R. H. Coase (1937) "The Nature of the Firm," Economica, New Series, 4, 16: 386- 405 (November 1937)R. H. Coase "The Nature of the Firm,"R. H. Coase "The Nature of the Firm," Lets talk about Coase as an introduction Lets talk about Coase as an introduction to the problem of What is a firm? to the problem of What is a firm?

3. 3 Coase (1937)

4. 4 Transaction Costs

5. 5 Using Marginalism

6. 6 Master and Servant The last part of Coase is about authority. The principal commands the agent. The last part of Coase is about authority. The principal commands the agent. Why is the principal the entrepreneur and not the worker? (not in Coase) Why is the principal the entrepreneur and not the worker? (not in Coase) Why does the residual claimant have the authority? (not in Coase) Why does the residual claimant have the authority? (not in Coase)

7. 7 Three Views Technological-Production Function Technological-Production Function Contractual-Nexus of Contracts Contractual-Nexus of Contracts Incomplete ContractsAuthority Incomplete ContractsAuthority

8. 8 The Technological View Avoiding competition (horizontal merger) Avoiding overly high prices for complementary products (not in Tirole) Allowing vertical price discrimination (ch 3) Economies of Scale (Economies of massed reserves, economies of scale from spreading fixed costs) (shape of cost curves) (natural monopoly) Economies of scope Economies of scope Avoiding sales tax

9. 9 Tirole p. 20. Why do economies of scale have to be exploited within the firm? p. 20. Why do economies of scale have to be exploited within the firm? This relates to Coase (1937) This relates to Coase (1937)

10. 10 Why Not One Big Firm? Williamsons Puzzle of Selective Intervention: why not merge two firms and then manage them just the same as before? (p. 21) One answer: we cannot contract to make the CEO of each firm a residual claimant. Think of Holmstroms Teams model (1982). Rasmusen and Zenger, ``Diseconomies of Scale in Employment Contracts,'' Journal of Law, Economics and Organization (June 1990), 6(1): 65-92. Rasmusen and Zenger, ``Diseconomies of Scale in Employment Contracts,'' Journal of Law, Economics and Organization (June 1990), 6(1): 65-92.

11. 11 Bargaining Power (Rasmusen) Two possible meanings: 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets 3) 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets 3) 2. The division of surplus (Apex gets 100%, Brydox gets 0%) vs. (Apex gets 20%, Brydox gets 80%)

12. 12 Bargaining: Why the Coase Theorem Breaks Down (pp. 22-24) (1) Possible pre-asymmetric info moves (2) Nature chooses buyer value v using density f(v) on [a,b] with seller cost c in (a,b). The buyer observes this. (3) The seller, with cost c, offers price p to the buyer. (4) The buyer accepts or rejects. This leads to inefficiency–-the Myerson-Satterthwaite problem. Seller proposing an offer at (1) would not help. Merging at (1) would help. So we should put buyer and seller in the same firm. OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism (footnote 29) OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism (footnote 29)

13. 13 Asset Specificity/The Hold-Up Problem (p. 24) (1) The buyer value is v=3. The seller can invest 2 to get c=0 or not invest, to keep c=4. (2) The buyer offers price p to the seller. (or, use 50-50 split) (3) The seller accepts or rejects. This leads to investment of 0. The buyer proposing an offer at (0) *would* help. Merging at (0) would help too. So we should put buyer and seller in the same firm. OR: give all the bargaining power to the investing party, i.e. the seller here. OR: give all the bargaining power to the investing party, i.e. the seller here.

14. 14 Asset Specificity/The Hold-Up Problem Example (p. 28) Joskow found that when coal quality is diverse, not many transportation methods, and few mines, then long- term contracts will be used (West US) In the opposite case, short-term contracts (spot markets) are used (East US)

15. 15 Authority (p. 30) Authority changes the threat point in bargaining. It changes, in a sense, bargaining power. Authority changes the threat point in bargaining. It changes, in a sense, bargaining power. Think of the UN Security Council. Suppose Russia and France do not care about Rwanda policy, but the US does. Is the effect of giving them veto power over US policy to change US policy? Think of the UN Security Council. Suppose Russia and France do not care about Rwanda policy, but the US does. Is the effect of giving them veto power over US policy to change US policy?

16. 16 Unconstrained Bargaining (pp. 31- 32) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2) The buyer value of the new feature is v>c with probability x and 0 otherwise. (3) Buyer and seller bargain for a price p for the feature. If they disagree, the new feature is not added to the product. Assume: bargaining splits the gains from agreement. Result: Underinvestment

17. 17 Seller Has Authority to Make Changes ( p. 32) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with probability x and 0 otherwise. (2.5) The seller decides whether to add the new feature to the product. The buyer can pay him to make him do it. Assume: bargaining splits the gains from agreement. Result: Underinvestment

18. 18 Buyer Has Authority to Make Changes ( pp. 32-33) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with probability x and 0 otherwise. (2.5) The buyer decides whether to add the new feature to the product, possibly being paid by the seller not to require it. Assume: bargaining splits the gains from agreement. Result: Overinvestment

19. 19 What if the New Feature Might Be Actually a Worsening for the Buyer? We can run that model with probability x of value v>c and probability (1-x) of value –y c and probability (1-x) of value –y<0 too. Then, buyer authority does not result in overinvestment, I think--- for reasons elucidated in Lyon and Rasmusen (2004) Then, buyer authority does not result in overinvestment, I think--- for reasons elucidated in Lyon and Rasmusen (2004)

20. 20 Lyon-Rasmusen (2004) Thomas P. Lyon, Eric Rasmusen. ``Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'' Journal of Law, Economics and Organization,20,1 (Spring 2004). Thomas P. Lyon, Eric Rasmusen. ``Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'' Journal of Law, Economics and Organization,20,1 (Spring 2004). Hart & Moore (1999) construct a model to show that contracts perform poorly when the state of the world is unverifiable and renegotiation cannot be ruled out. They implicitly assume that one player can extort payment from another by threatening to take an inefficient action which hurts both of them. Without this assumption, a simple ``buyer option" contract can implement the first- best even as complexity becomes severe. The model is a good illustration of the need to be careful with the ideas of ``one party has all the bargaining power'' and ``one party can make a take-it- or-leave-it offer.'' Hart & Moore (1999) construct a model to show that contracts perform poorly when the state of the world is unverifiable and renegotiation cannot be ruled out. They implicitly assume that one player can extort payment from another by threatening to take an inefficient action which hurts both of them. Without this assumption, a simple ``buyer option" contract can implement the first- best even as complexity becomes severe. The model is a good illustration of the need to be careful with the ideas of ``one party has all the bargaining power'' and ``one party can make a take-it- or-leave-it offer.''

21. 21 More Variants on the Hold-Up Game More Variants on the Hold-Up Game Holdup 4: Seller sets price. Buyer MAY buy. (Buyer may not buy anywhere else) Holdup 4: Seller sets price. Buyer MAY buy. (Buyer may not buy anywhere else) Holdup 5: Set a price in advance, and buyer MAY buy if seller is willing. Holdup 5: Set a price in advance, and buyer MAY buy if seller is willing. Holdup 6: Set a price in advance, and buyer MAY buy even if seller is unwilling. Holdup 6: Set a price in advance, and buyer MAY buy even if seller is unwilling. Holdup 7: Set a price in advance, and buyer MUST buy if seller is willing. Holdup 7: Set a price in advance, and buyer MUST buy if seller is willing. Variant on the game: Variant on the game: Seller can produce a good of low quality, with value 0, if he fails to invest. What does that imply for Contracts 1,2,3, 4, 5, 6, and 7? Seller can produce a good of low quality, with value 0, if he fails to invest. What does that imply for Contracts 1,2,3, 4, 5, 6, and 7?

22. 22

23. 23 A link to the course website http://www.rasmusen.org/g604/0.g604.htm