Lecture 11Lecture 11Economic Theory of the Economic Theory of the FirmFirmThere are two views of the firm:There are two views of the firm:

1. Neoclassical (traditional) theory:1. Neoclassical (traditional) theory: Firm is a calculating entity, that makes Firm is a calculating entity, that makes

decisions, buys inputs, making output, decisions, buys inputs, making output, and selling for profit for lossand selling for profit for loss

2. Property rights theory:2. Property rights theory: Firm is a collection of contracts between Firm is a collection of contracts between

owners of resources, who wish to combine owners of resources, who wish to combine portions of their resources, for some portions of their resources, for some period, for some purposeperiod, for some purpose

Traditional Theory of the Traditional Theory of the FirmFirm Traditionally, the firm — headed by the Traditionally, the firm — headed by the

entrepreneur or manager — makes decisions:entrepreneur or manager — makes decisions:– What to produce?What to produce?– When and how to produce it?When and how to produce it?– How much to produce?How much to produce?– What is its price?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 recipeRelates inputs and outputs — like a recipe

q = q (x,y,z)q = q (x,y,z) q is outputq is output x, y, z are inputsx, y, z are inputs

– The exact form depends on technology, etc.The exact form depends on technology, etc.

A production functionA production function

A production function is often a mechanical view of A production function is often a mechanical view of production:production:– 1 shovel of cement1 shovel of cement– 3 shovels of sand3 shovels of sand– 5 shovels of stone5 shovels of stone– 4 liters of water4 liters of water– Use labor to mix cement, sand, and stone for 1 Use labor to mix cement, sand, and stone for 1

minuteminute– Add more water to get right textureAdd more water to get right texture– Use labor to mix ingredients for 2 minutesUse labor to mix ingredients for 2 minutes– Output: 12 liters of wet concreteOutput: 12 liters of wet concreteMost of this is engineering. The role of economics Most of this is engineering. The role of economics

is limited to the importance of price, substitutes, is limited to the importance of price, substitutes, etc. Important concepts, but not difficult to etc. Important concepts, but not difficult to grasp.grasp.

Property Rights Theory: Property Rights Theory: Firms and MarketsFirms and Markets

The tradeoff:The tradeoff:– Market is informationally Market is informationally

efficient efficient – The firm is contractually efficientThe firm is contractually efficient

The balance between these two The balance between these two determines the methods of determines the methods of production chosen by an production chosen by an entrepreneur or managerentrepreneur or manager

What Kind of Organizational What Kind of Organizational Form to Choose?Form to Choose?

A key role of managers is to procure A key role of managers is to procure inputs in the least cost manner.inputs in the least cost manner.

If not accomplished, costs will be higher If not accomplished, costs will be higher than needed and the firm will lose than needed and the firm will lose profits and perhaps go bankrupt.profits and perhaps go bankrupt.

Basic Question: To achieve greater Basic Question: To achieve greater efficiency, does a manager procure efficiency, does a manager procure inputs from the market or procure inputs from the market or procure inputs within the firm?inputs within the firm?

How to obtain needed How to obtain needed inputs?inputs?Consider possible stages of Consider possible stages of

production:production:Obtaining raw materialsObtaining raw materialsObtaining finished partsObtaining finished partsAssemblyAssemblyTransportation servicesTransportation servicesStorageStorageWholesalingWholesalingRetailingRetailing

How to obtain needed How to obtain needed inputs?inputs?

General services needed by a firm:General services needed by a firm:AccountingAccountingFinance (including credit service)Finance (including credit service)Human ResourcesHuman ResourcesLegal ServicesLegal ServicesMarketing (advertising, etc.)Marketing (advertising, etc.)Janitorial ServiceJanitorial Service

Who is to provide such services?Who is to provide such services?

Who provides needed Who provides needed services and materials?services and materials?

Should the firm produce within the Should the firm produce within the organization or buy from the outside?organization or buy from the outside?

There is no one answer—many There is no one answer—many conditions will determine outcome.conditions will determine outcome.

Think of the great range of options:Think of the great range of options:Spot markets Spot markets → Long Term Contracts →→ Long Term Contracts →Vertical Integration (produce in house)Vertical Integration (produce in house)

Methods of Obtaining Methods of Obtaining InputsInputs

1.1. Spot market or spot exchange—Spot market or spot exchange—Buyers and sellers exchange, but Buyers and sellers exchange, but might not deal again. Benefit: deal might not deal again. Benefit: deal with specialized sellers, usually low with specialized sellers, usually low transaction costs. The provider is transaction costs. The provider is not integrated into the firm. not integrated into the firm.

Possible problem: exploitation by Possible problem: exploitation by seller who knows we are ignorant or seller who knows we are ignorant or inconsistent quality.inconsistent quality.

Methods of Obtaining Methods of Obtaining InputsInputs2. Contracts—2. Contracts—

Legally based extended relationship Legally based extended relationship between buyer and seller.between buyer and seller.Benefits: specialization; ability to Benefits: specialization; ability to terminate sellers who do not perform; terminate sellers who do not perform; reduction in exploitation compared to reduction in exploitation compared to spot markets. spot markets.

Problems: costly in complex Problems: costly in complex environments; incentives to act badly.environments; incentives to act badly.

Many Forms of ContractsMany Forms of Contracts

Services Services (Deere and Ryder Trucks; (Deere and Ryder Trucks; UPS and Toshiba warranty laptop UPS and Toshiba warranty laptop repairs; UPS and Jockey; Japanese call repairs; UPS and Jockey; Japanese call centers in Dalien)centers in Dalien)

Joint Ventures Joint Ventures (foreign firms in China)(foreign firms in China) Leases Leases (office buildings)(office buildings) Franchises Franchises (McDonalds, car dealers)(McDonalds, car dealers) Strategic Alliances Strategic Alliances (Merck & Astra)(Merck & Astra)

Methods of Obtaining Methods of Obtaining InputsInputs

3. Vertical Integration—3. Vertical Integration—(Non-market relations)(Non-market relations)

When a firm chooses to produce an input When a firm chooses to produce an input internally rather than contract with internally rather than contract with outsiders. Benefits: reduced opportunistic outsiders. Benefits: reduced opportunistic behavior by outsiders and fewer behavior by outsiders and fewer contracting costs. contracting costs.

Problems: lost specialization and increased Problems: lost specialization and increased organizational (managerial) costs.organizational (managerial) costs.

When Is Vertical Integration When Is Vertical Integration Most Likely to Be Most Likely to Be Necessary?Necessary?

To protect brand name (goodwill) To protect brand name (goodwill) protectionprotectionExamples: Sony, Prada, Ralph Examples: Sony, Prada, Ralph LaurenLauren

When there are specific assets or high When there are specific assets or high sunk costs or contracts hard to sunk costs or contracts hard to enforce. Examples: pipeline; GM-enforce. Examples: pipeline; GM-FisherFisher

Methods of Obtaining Methods of Obtaining InputsInputs

Summary:Summary:Are there specialized investments relative Are there specialized investments relative

to contracting costs? If no—likely to use to contracting costs? If no—likely to use spot market.spot market.

If yes—is the cost of contracting high If yes—is the cost of contracting high relative to the cost of integration? If yesrelative to the cost of integration? If yes—vertical integration; if no—contracts —vertical integration; if no—contracts with outside suppliers.with outside suppliers.

Think about chickens.Think about chickens.

Recent Example: FordRecent Example: Ford Ford used annual bidding competition Ford used annual bidding competition

to achieve low cost suppliers for auto to achieve low cost suppliers for auto parts ($7 billion a year). parts ($7 billion a year).

Problems: high administrative cost, Problems: high administrative cost, bankruptcy by suppliers (Delphi), bankruptcy by suppliers (Delphi), quality control unevenquality control uneven

Solution: multi-year contracts with Solution: multi-year contracts with fewer suppliers (down from 2,500 to fewer suppliers (down from 2,500 to 1,000); closer working relationship; 1,000); closer working relationship; estimated savings of 10% per year.estimated savings of 10% per year.

Agency CostsAgency Costs Employees or contractors not behaving as Employees or contractors not behaving as

they should — is a part of what we call they should — is a part of what we call Agency Costs or Agency Problems.Agency Costs or Agency Problems.

Agency costs exist as a problem Agency costs exist as a problem whenever a principal hires an agent to act whenever a principal hires an agent to act on his behalf.on his behalf.

Solving this universal problems is a key Solving this universal problems is a key managerial problem in managing managerial problem in managing personnel and in controlling costs.personnel and in controlling costs.

A Major Drawback of Firms: A Major Drawback of Firms: Agency CostsAgency Costs

Agency costs arises from the separation of ownership Agency costs arises from the separation of ownership and control.and control.

Owners of firms are interested in profit maximization.Owners of firms are interested in profit maximization.Managers, employees, and suppliers are interested in Managers, employees, and suppliers are interested in

maximizing their own self-interests. maximizing their own self-interests.

How do we give employees incentives to act as if How do we give employees incentives to act as if they were owners of the firm? How do we get they were owners of the firm? How do we get employees to not shirk—that is, work as hard as employees to not shirk—that is, work as hard as they can in the manner the owners would want? It they can in the manner the owners would want? It is a matter of is a matter of incentives.incentives.

Agency Costs . . .Agency Costs . . .

These are a problem because we are These are a problem because we are human. If we “cheat” ourselves, then no one human. If we “cheat” ourselves, then no one else bears the cost. So the one-person firm else bears the cost. So the one-person firm is efficient and does not suffer agency costs.is efficient and does not suffer agency costs.

It is natural for us to want to exploit others: It is natural for us to want to exploit others: get others to pay more than they agreed to get others to pay more than they agreed to pay or we produce less than we agreed to pay or we produce less than we agreed to produce. That is, a divergence in interest produce. That is, a divergence in interest between principal and agent in a multi-between principal and agent in a multi-person organization and in contracts.person organization and in contracts.

MonitoringMonitoring

We have incentives to We have incentives to shirkshirk – take more than – take more than we should or work less than we should. we should or work less than we should. Monitoring is costly, so sensible to accept Monitoring is costly, so sensible to accept some losses. Many forms of monitoring some losses. Many forms of monitoring exist (spot checks, etc.).exist (spot checks, etc.).

Usually there is unequal (asymmetric) Usually there is unequal (asymmetric) information between parties. One knows information between parties. One knows more than the other and can exploit that.more than the other and can exploit that.Examples: Person selling used car.Examples: Person selling used car.

Buy insurance (buyer exploits seller)Buy insurance (buyer exploits seller)

Monitoring, Bonding & SignalsMonitoring, Bonding & Signals How do we assure customers that we How do we assure customers that we

can be trusted, so they should contract can be trusted, so they should contract with us?with us?

Various devices:Various devices:Fixed price contracts; Bonds; Warranties;Fixed price contracts; Bonds; Warranties;Future price guarantees. Future price guarantees. Less formal: Reputation. This matters Less formal: Reputation. This matters

greatly in the market. We pay premiums greatly in the market. We pay premiums to deal with firms with good reputations.to deal with firms with good reputations.

Entrepreneurs and their Entrepreneurs and their FirmsFirms Key Managerial Problem:Key Managerial Problem:Giving employees incentives to act Giving employees incentives to act as as

ifif they are owners. they are owners.The entrepreneur or top manager The entrepreneur or top manager

must cede authority to others. The must cede authority to others. The issue is: How do we structure an issue is: How do we structure an organization to reduce agency costs? organization to reduce agency costs? The movement has been in this The movement has been in this direction; especially in knowledge-direction; especially in knowledge-based production.based production.

Decentralization: Pros & Decentralization: Pros & ConsCons Empowering workers and managers.Empowering workers and managers.BENEFITS:BENEFITS:

1. More effective use of local knowledge — 1. More effective use of local knowledge — those closest know the mostthose closest know the most2. Conservation of senior management — 2. Conservation of senior management — top people cannot know or do top people cannot know or do everythingeverything3. Training & motivation for local 3. Training & motivation for local managers: managers: helps attract and keep helps attract and keep good managers good managers and train future top and train future top managersmanagers

Decentralization . . . Decentralization . . .

Empowering workers and managers:Empowering workers and managers:COSTS:COSTS:

1. Agency costs—1. Agency costs—shirking; self-dealing — so control and shirking; self-dealing — so control and monitoring measures neededmonitoring measures needed2. Coordination costs and failures —2. Coordination costs and failures —duplication; pricing errorsduplication; pricing errors3. Less effective use of central information—3. Less effective use of central information—local managers cannot know all local managers cannot know all information the central managers here, information the central managers here, so so have inferior knowledgehave inferior knowledge

Team Production: Team Production: Increasing or Decreasing Costs?Increasing or Decreasing Costs?

Create teams of people with different expertise to Create teams of people with different expertise to make decisions—make decisions—Ex.—Hallmark Cards had teams of art, design, Ex.—Hallmark Cards had teams of art, design, production and marketing assigned by holiday with production and marketing assigned by holiday with decision rights rather than move produce from decision rights rather than move produce from functional area to area—cut time in half.functional area to area—cut time in half.

Benefits—Improved use of specific knowledge and Benefits—Improved use of specific knowledge and employee “buy in” due to better information, more employee “buy in” due to better information, more cooperation & less blame.cooperation & less blame.

Costs—Collective-action and free-rider problems.Costs—Collective-action and free-rider problems.Same thing in car production—team development Same thing in car production—team development

tried at Chrysler; separate functional areas at GM. tried at Chrysler; separate functional areas at GM. Tradeoffs.Tradeoffs.

Decision Management & Decision Management & ControlControl

Agents (managers within a firm) do Agents (managers within a firm) do not bear the full cost of their not bear the full cost of their actions, so cannot be delegated actions, so cannot be delegated both decision management and both decision management and control — hierarchy still necessary. control — hierarchy still necessary. Make authority and lines of control Make authority and lines of control clear. Clear communications — top clear. Clear communications — top down and down up — are critical.down and down up — are critical.

Questions: How Do We Questions: How Do We Overcome Agency Costs?Overcome Agency Costs? The larger the organization, or the greater The larger the organization, or the greater

the distance from the owners to the the distance from the owners to the workers, the more likely that agency costs workers, the more likely that agency costs will become significant —large corporation will become significant —large corporation look more like an inefficient government look more like an inefficient government agency. What economic incentives do agency. What economic incentives do firms take to try to give workers proper firms take to try to give workers proper incentives?incentives?

What about ESOPs? Compensation What about ESOPs? Compensation schemes?schemes?

Question: Large Question: Large Organization with Simple Organization with Simple MonitoringMonitoring

Mary Kay Cosmetics grew from sale Mary Kay Cosmetics grew from sale of $200,000 in 1963 to over $600 of $200,000 in 1963 to over $600 million in 1993, 30 years later. The million in 1993, 30 years later. The product is common and very product is common and very competitive. The key to growth was competitive. The key to growth was measurement of employee effort measurement of employee effort and rewards. What was it?and rewards. What was it?

Question on Team Question on Team IncentivesIncentives Suppose different numbers of people are Suppose different numbers of people are

assigned to pull a rope “as hard as you assigned to pull a rope “as hard as you can.”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) How does the pulling force (work effort)

per person change across these three per person change across these three cases?cases?

Incentives of ManagersIncentives of Managers In the fast-food industry, about 30% of In the fast-food industry, about 30% of

stores are company owned and run by a stores are company owned and run by a salaried manager. About 70% of the salaried manager. About 70% of the stores are run as franchises by owner-stores are run as franchises by owner-operators who split profits with the parent operators who split profits with the parent company. 1) Which kind of store would company. 1) Which kind of store would you think would tend to be more you think would tend to be more profitable? profitable? 2) Why then does the parent choose to 2) Why then does the parent choose to own some? Where would they be located?own some? Where would they be located?3) Would you expect employees to see a 3) Would you expect employees to see a difference in the managers?difference in the managers?