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COMPARING FIRMS, CONTRACTS, AND MARKETS

COMPARING FIRMS, CONTRACTS, AND MARKETS. Birger Wernerfelt MIT. Some simple points about the theory of the firm . Firms are “common”, so the theory should be driven by “common” factors It is unlikely that one institution solves two problems (TCE: Ex ante and ex post distortions)

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COMPARING FIRMS, CONTRACTS, AND MARKETS

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  1. COMPARING FIRMS, CONTRACTS, AND MARKETS Birger Wernerfelt MIT

  2. Some simple points about the theory of the firm • Firms are “common”, so the theory should be driven by “common” factors • It is unlikely that one institution solves two problems (TCE: Ex ante and ex post distortions) • It is unlikely that two institutions are driven by the same force (PRT: Asset ownership and employment) • It is a plus if the theory resonates with managers • It should portray one party as giving “orders”

  3. Combination of old premises gives new insights • Bargaining costs (Coase, 1937) • Gains from specialization (Adam Smith, 1776) Adapting without losing gains from specialization • Why Markets, Firms, or Contracts? • When? • Other implications of the theory • Scope of the firm

  4. About bargaining costs • Many kinds: Incurred before, during, or after • Have a bad name • Some can be micro-founded: For ex. investment in information/bargaining power (also rent seeking literature) • Sub-additive – exhibit economies of scale

  5. Experiment on bargaining cost • Bilateral, 30 sequential trades, full information • Offer a price for the current trade or an average price for rest of them • Small cost of pooling the residual trades: Domains overlap and all trades have to be executed under a pooling contract. • Results point to positive, sub-additive bargaining cost

  6. Gains from many kinds of specialization • Performing the same service many times (Plumber) – service specialist • Working for the same business many times (Superintendent) – business specialist • Doing everything in the same way (Min time or cost, Max durability, appearance, or quality …) - standardization

  7. Workhorse model: Fixed firm size • Three periods t = 0, 1, 2. Time preference δ • Services (S, s) and businesses (B, b) • Workers (W, w) and entrepreneurs (E, e) • In every period, each business needs a specific service and each worker can perform one • For now │B│=│W│=│E│ • “Type” of b is εb ~ F(0, σB), type of s is εs~G(0, σS)

  8. Two frictions Adaptation vs. standardization: -If w performs s for b, the ideal “level” isqw = εb+ εs -However, standardization requires that the level is constant over time. With standardization, second period base costs are c* instead of c. (Assume: Non-standardization is prohibitively costly) Bargaining costs -Positive for bilateral price determination -Sub-additive, taking values between K and K

  9. Bargaining bins Players in a bargaining bin may negotiate a single price in every period. The bin is defined by a set of services to which this price applies. For example, among {0, 1}│S│ x {0, 1}│B│ possibilities, it can be “service s’ for any b ”, “service s’ for b’”, “any s for b’ ”, or “no services”.

  10. Strategies • An entrepreneur selects first and second period bargaining bins as functions of her needs for those periods. • A worker selects first and second period bargaining bins as functions of his assignment in the immediately prior periods and, in the first period, a level at which to standardize.

  11. Sequence of events: Period 0 -Each entrepreneur is randomly and permanently matched with a business. Workers and entrepreneurs are randomly matched. All εb, εs are realized. -Business (entrepreneur) needs for period 0 are realized. Workers learn the εbof the business with which they are matched and the εsof the service it needs.

  12. Sequence of events: Period 1 -Business needs for period 1 are realized. -Entrepreneurs and workers distribute themselves into bargaining bins and negotiate as indicated. -Entrepreneurs and workers in each bin are randomly matched. -Workers choose the levels qw on which they standardize. -Workers perform the agreed upon services and learn the associated εb, εs.

  13. Sequence of events: Period 2 -Business needs for period 2 are realized. -Entrepreneurs and workers distribute themselves into bargaining bins and negotiate as indicated. -Entrepreneurs and workers in each bin are randomly matched. -Workers perform the agreed upon services (and learn the associated εb, εs).

  14. Equilibria • An equilibrium is a Market if all bargaining bins consist of │E│/ │S│ entrepreneurs needing the same service as well as │E│/ │S│ workers who are service-specialists on it, and the members negotiate a price for that service only • An equilibrium is Employment if all period 1 bargaining bins consist of one worker and the entrepreneur for whom he worked in period 0, and the members negotiate a single price for all services. • An equilibrium is Sequential Contracting if all bargaining bins consist of one worker and the entrepreneur for whom he worked in period 0, and the members negotiate a price for the service needed by the entrepreneur in the current period.

  15. Proposition 1 There exists three regions in [σB2, σS2, K, K, δ] where Markets, Employment, and Sequential Contracting are weakly more efficient that all other sub-game perfect equilibria. σB2 – σS2 Sequential Contracting Employment Market δ

  16. Firms are more likely to be used when frequent adaptation is necessary A car consists of 36 “systems” Changes in one may require changes in others 36x36 matrix of frequency w. w. “coordinated change is needed” Which systems should be co-produced? Data from 8 cars, very different solutions This is an enormously big optimization problem Firms do extremely well: 4 of 8 beat 99,995/100,000 random designs, 1 beats all.

  17. Asset ownership • An asset is owned by the player whose decisions most influence its depreciation • 50 carpenters, 41 tools • Employees own 40% of the tools • “A hammer is easily lost or stolen” - employee • “Some projects are more likely to damage a hammer”- boss • Brand specific skills do not matter – no effect

  18. Growing a business • Some workers can be both business – and service specialists. Very efficient • Worthwhile to expand to different but “adjacent” businesses • This stops when the portfolio becomes too “unfocused”

  19. PROPOSITION 2 If the εbs are uniformly distributed on [0, 1] and an entrepreneur can meet all needs from n [0, 1] businesses by hiring n service-specialists as employees, The optimal scope is an interval and profits are maximized at n = Min{2½(2v – c – c* - K)½, 1} PS: 2v-c-c*-K is average net profit per worker

  20. Discussion 1: Summary • Firms vs Markets vs Contracts: New forces - Advantages of specialization - Frequency of change - Magnitude of demand - Size of firms • Limits to firm size: Resonate with practitioners -Leverage excess capacity of resources -Focus on what you are good at

  21. Discussion 2: Turning things upside down • Asset ownership -I own the assets because I am the boss • Flatter incentives in firms -boss may ask employees to do other things • Delegation -it is too costly to agree on everything • Incomplete contracts - because they can be renegotiated • More communication inside firms -loss of bargaining power matter less

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