CLASS 2 NOTES The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

CLASS 2 NOTES

The Economics of Business

Harvard Extension SchoolInstructor: Bob WaylandTeaching Assistant: Natasha Wambebe

Outline incomplete without oral presentation

2

Revisit Class 1

What are the four foundations of our foundation as found in Adam Smith’s Wealth of Nations?

What is the primary driver of economic wealth?

What is necessary to realize the benefits of specialization?

How are economic and biological systems similar?


3

Revisit Class 1…

What distinguishes positive from normative economics?What characteristic of using markets did Coase suggest

stimulated the emergence of firms?What change in the characteristics of the U.K. textile

industry before and after the industrial revolution illustrate Coase’s argument?

What factors, ceteris paribus, tend to increase firm size?

What factors did Coase suggest lead eventually to constraints on the size and scale of firms?

What determines the ultimate limit to firm size, how does this relate to the concepts of variable proportion diminishing marginal returns?


4

Alchian and Demsetz, Production, Information Costs, and Economic Organization

Alchian and Demsetz expounded on the importance of cooperation as an explanation of firms Productivity increases through cooperative,

team based production Demand for organizations to facilitate that

cooperation More detailed picture than Coase, sought to:

Explain the conditions when cooperative specialization benefited from organization or market

Explain the structure of the organization


5

Alchian and Demsetz, continued

Argued that Coase overstated power of hierarchy over market

Firms do not own all of their resources

Power to deploy and discipline no greater than through market Fundamental basis for firms is superior ability to organize cooperative

efforts Cooperative activities (teams) are difficult and costly to

meter (manage) Joint, combined, simultaneous individual efforts Specialized knowledge and careful observation required to meter joint or

team effort


6

Alchian and Demsetz

A team production function: z = f(x,y) is described mathematically by non-zero second cross partial derivatives: ∂f2/∂x∂y ≠ 0.

E.g. if z = f(x,y) = x3 + x2y3 -2y2 , then

fx = 3x2 + 2xy3, and fxfy =∂/∂y (3x2 + 2xy3) = 6xy2 for all x,y ≠ 0

But, if z = f(x,y) = x3 – 2y2 then fx = 3x2 , and

fxfy = ∂/∂y (3x2) = 0

Note: This is a little warm-up or warning shot exercise. If you find this incomprehensible your calculus is probably not up to dealing with some future articles such as Klepper


7


Team production makes shirking difficult to observe

Person more prone to shirk as a team member than in task involving separable work Shirker gains all of leisure Shirker sacrifices 1/n of reward

Manager seeks to minimize shirking subject to costs of metering (optimal level of shirking)


8


Firm (or principal) is the common contracting party for all team members

Manager has claim on the residual value created by the team

Centralized contracting is important characteristic of

firm Reduces re-contracting costs Promotes familiarity and knowledge to better observe and

counteract shirking


9


The classical firm* is defined as a contractual structure with:

1. Joint input production; 2. Several input owners; 3. One party who is common to all the contracts of the joint

inputs who4. Has rights to renegotiate any input's contract independently

of contracts with other input owners;5. Holds the residual claim; and6. Who has the right to sell his central contractual residual

status. The central agent (principal) is called the firm's owner

and/or the employer*”Our exposition also suggests a definition of the classical firm –something crucial that was heretofore absent.” (p784) I am unclear on exactly how they can “retroactively” define a classical firm.


10


Alchian and Demsetz see limits to scale of the firm consistent with Coase but more specific than simply a “generic” recourse to diminishing returns to management. The greater the interdependencies among functions, and the

needs for specialized knowledge to manage those interdependencies, the more important is centralized contracting

The larger a firm and the more different bodies of knowledge it must master to manage interdependencies, the more difficult and expensive it becomes to perform efficiently.

Keep these points in mind when we discuss Simon and the limits to human cognitive powers


11


Firm type defined by residual sharing arrangements Profit Sharing Firms Socialist Firms The Corporation Mutual and Non-profit Firms Partnerships Employee Unions (not firms but monitoring service)


12


Profit sharing firms are generally found in small team size settings Facilitates self-policing for small teams (non-

specialized monitoring) Under equal profit sharing schemes incentives to

shirk directly related to the size of the team Within large firms, equal sharing diffuses incentives of

management


13


Socialist firms often marked by broad sharing of residual value (if any) Managers have no special claim on residual, lack

incentive Proxies for residual; e.g. goals, evaluations, etc. used Worker evaluations, where used, may encourage

tolerance of shirking


14


Corporations are marked by diffuse ownership Small shareholders have little incentive to meter Liquidity limits risk

Managers are policed to some extent by Internal competition Potential change of ownership (raiders, LBOs, etc)

Perhaps better to view stockholders as investors, not owners (How would the SEC react to this?)


15


Mutual and non-profit firms No market valuation Often compensated on “comparable” basis Rewarded for “inputs’


16


Partnerships Frequently for jointly produced artistic and

intellectual productions Small scale permits self-policing Often formed among relatives or friends Once common in “professional services” but replaced by

LLCs to limit liability


17


Employee unions Not firms, usually don’t create tradable products

and services Do provide monitoring services for members Some provide training, hiring hall, and insurance

services Serious agency problems with respect to

members in some cases


18


Input ownership Ownership resides where expected returns are

greatest Asset ownership arrangements are very similar to

share-cropping contracts – basic form of risk-sharing contracting

Costs of asset use include depreciation and loss of service due to carelessness


19


Firms will own those assets they can economically apply and monitor (owner absorbs financial and physical depreciation)

Centralized monitoring of abuse worthwhile for expensive physical assets Typically owned by company May be rented if cost, including premium for expected

abuse, is lower than ownership costsLater, asset ownership was viewed as a

means to avoid “hold-up” and to exercise control over users


20


Employees will own assets if best able to realize the value of their service and protect them from abuse

Workman can more easily monitor abuse of his tools

Dedicated assets, even trucks, often employee owned

Specialized tools of the trade, frequently owned by workers


21


Firm as a Specialized Market Institution for Collecting, Collating, and Selling Information

Firm can be considered a “private market” Nuanced contrast to Coase “substitute” Firm is in position to evaluate and direct resources better than

those resources could on their own Resources may find it better to work (sell their services) within a

private market (firm) than through the public markets Analogous to the private market of a department store Efficient production with heterogeneous inputs

Not always better resources Better knowledge about those resources Combinations of resources Adjustments in prices

Do public markets suffer from communal ownership?


22

Harold Demsetz, The Theory of the Firm Revisited

Follow-up to earlier work with AlchianObserves need for greater emphasis on information in

explaining firmsDescribes the failure of “perfect decentralization”

model to explain firmsDiscusses some problems with TCE

Identifies the need to consider both transactions and production cost across internal and external options (later addressed by Williamson)

Notes that output or the producing firm may be purchased, need to clarify the relevant transactions costs

Traces confusion to lingering notion of free information


23

Harold Demsetz, Revisited…

Moral Hazard, Shirking and Opportunism Attention turned to incentive alignment Dealing with moral hazard involves costs Close ties between asset specificity and

opportunism Firm-like production results in a special form of

productivity


24

Harold Demsetz, Revisited…

Firm-Like Organization “The firm properly viewed is a ‘nexus’ of contracts.” Questions involve:

The persistence of certain types of contracts The variation in other types of contracts that are “more-or-less”

included in the nexus The (horizontal and vertical) scope of activities covered by these

contracts We have now the tensions among forces shaping relationships

Specialization (idiosyncrasy) increases productivity but also vulnerability

Cooperative, team-based output (through either firm or contract) to achieve benefits of specialization

Human nature gives rise to moral hazard, opportunism, shirking, etc. and requires management


25

George Stigler, The Division of Labor is Limited by the Extent of the Market

Title is borrowed from Adam Smith’s observationRicardo, Senior, and J.S. Mill observed the

phenomenon of industrial increasing returnsDilemma: If further division of labor continuously

lowers costs for larger outputs entrepreneurs would expand and monopolize industries

Decreasing cost functions and increasing returns to scale were troublesome concepts and neglected

In 1928 Allyn Young re-emphasized Smith’s theorem but couldn’t successfully integrate into the theory of the firm


26

George Stigler, The Division of Labor is Limited by the Extent of the Market…

Stigler observed the “life cycle” of firms from fully vertically integrated to more focused entities and then re-integrating as the industry declined

An evolutionary concept analogous to species interacting with their environment or habitat (not stated as such by Stigler)

Firms may be seen as performing a series of distinct (separable) operations

These operations can be defined in terms of common rates of output and therefore summed vertically

Highly vertically integrated firms typically engage in operations with various cost curve shapes


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28


Vertical integration occurs also when the market or price system does not clear at MC of the product and Marginal-Value Product.


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Outsourcing – think of it as vertical de-integration Outsourcing is simply buying rather than making – the original

Coasian choice Stigler’s life cycle or evolutionary model can explain some

outsourcing Much (most?) outsourcing is compelled by market forces and

not particularly discretionary Society’s overall wealth increases with the increase in

specialization Some particular people may be hurt In some “clusters” the existence of a commonly accessible

source for decreasing cost operations makes it much easier to start new specialized firms.


30

Next Week

Uncertainty, evolutionary economics, firm selection and survival Alchian, “Uncertainty, Evolution, and Economic

Theory” Nelson and Winter, “Evolutionary Theorizing in

Economics”

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Documents

CLASS 2 NOTES The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe