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CH10: Nature of Firms

CH10: Nature of Firms. HKALE Economics References: Advanced Level Microeconomics, LAM pun-lee, CH 16 A-Level Microeconomics, CHAN & KWOK, CH 18 HKALE Microeconomics, LEUNG man-por, CH 15. The Invisible Hand. Adam Smith: the principle of "enlightened self interest “

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CH10: Nature of Firms

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  1. CH10: Nature of Firms HKALE Economics References: Advanced Level Microeconomics, LAM pun-lee, CH 16 A-Level Microeconomics, CHAN & KWOK, CH 18 HKALE Microeconomics, LEUNG man-por, CH 15 By Mr. LAU san-fat

  2. The Invisible Hand • Adam Smith: the principle of "enlightened self interest“ • Within the system of capitalism, an individual acting for his own good tends also to promote the good of his community By Mr. LAU san-fat

  3. The Invisible Hand • ‘Every individual … generally neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.’ (Adam Smith, The Wealth of Nations) By Mr. LAU san-fat

  4. The Invisible Hand • Any social benefits that have accrued are simply a by-product of their striving for selfish reward • Smith’s proposal is merely that in a free market, people usually tend to produce goods desired by their neighbours By Mr. LAU san-fat

  5. The Invisible Hand • Smith did not assert that all self-interested labor necessarily benefits society • The tragedy of the the commons is an example where self-interest tends to bring an unwanted result By Mr. LAU san-fat

  6. Transactions with Invisible Hand • Without a firm, a buyer has to make a series of contracts with different sellers/input owners directly for getting what he wants. • Market participants respond sensitively to market price signals in allocating resources for maximizing their own wealth. By Mr. LAU san-fat

  7. Transactions with Invisible Hand • To buy a product, a consumer has to negotiate and deal with each sellers of different product components. • To buy a product component, an individual has to pay for that ‘product’ and the factor services involved indivisibly. By Mr. LAU san-fat

  8. Transactions with Invisible Hand • Any invisible-hand-guided transaction made implies that there is no way to separate product market transaction (PT) from factor market transaction (FT). By Mr. LAU san-fat

  9. The Visible Hand - Firm • A firm is characterized by having an entrepreneur or manager who makes contracts with and gives directions to the input owner in the factor market, and selling products to the buyer in the product market. By Mr. LAU san-fat

  10. Does a Firm Exist? • Does a firm exist when a boy provides shoe-shinning service in the street? • It depends on whether the boy is directed by somebody to do the shinning job. By Mr. LAU san-fat

  11. Why Firms Exist? • Argument 1: Specialization and coordination • With increasing complexity of specialization and division of labor, some integrating or coordinating forces from the entrepreneur are needed for preventing the economy from collapsing into chaos. By Mr. LAU san-fat

  12. Why Firms Exist? • Counter-arguments: • Specialization does not necessarily lead to chaos • The price mechanism has already acted as an integrating force • Decisions made by the entrepreneur may not be superior to consumer decisions reached through the price mechanism • Specialization and coordination could be realized even without firms By Mr. LAU san-fat

  13. Why Firms Exist? • Argument 2: Risk and uncertainty • With uncertainty, the entrepreneur becomes a professional in advising production decision and so is entitled to having power of directing others' work. Other input owners are willing to be directed as they are guaranteed a proxy payment, regardless of the market conditions. By Mr. LAU san-fat

  14. Why Firms Exist? • Counter-arguments: • People with better knowledge or judgment may get their rewards not by actively bearing risk of production, but by making contracts with people who are engaged in production. • It is possible to give a guaranteed reward to a worker provided that certain acts stipulated in the contract are performed without any implication of direction. By Mr. LAU san-fat

  15. Why Firms Exist? • Counter-arguments: • The employer-employee relationship may not guarantee the existence of firms as it is never clear whether it is the entrepreneur who employs the workers or the workers who employ the entrepreneur. By Mr. LAU san-fat

  16. Why Firms Exist? • Argument 3: Solving the shirking problem • It is costly to measure individual contributions of team production and so it is costly to detect whether a given team member is shirking or by how much. • Therefore, there is a need to hire an outsider to monitor the productive activity of all team members and check their performance. By Mr. LAU san-fat

  17. Why Firms Exist? • Counter-arguments: • The monitor himself is subject to the temptation to shirk. (The problem can be solved by making the monitor as the residual claimant) • Prof Cheung argues that the shirking problems will vary only in degree and in kind, depending on the form of contract chosen or how the property or service transacted is measured and priced. By Mr. LAU san-fat

  18. Why Firms Exist? • Counter-arguments: • If individual contributions to a finished product are priced accurately in the market or within a firm, that person would be less inclined to shirk. If so, why should productive activities be coordinated by firms instead of price mechanism. • The emergence of firms is not for solving shirking, however, it is due to the presence of transaction cost that causes shirking. By Mr. LAU san-fat

  19. Why Firms Exist? • Argument 4: Avoiding sales tax • A sales tax is a turnover tax imposed on market transactions and not on the same transactions organized within a firm. • Such a regulation would bring firms into existence to evade taxes which would other not exist. By Mr. LAU san-fat

  20. Why Firms Exist? • Counter-arguments: • R. Coase argues that a sales tax would merely tend to make firms bigger than they would otherwise be. • If so, this argument assumes the prior existence of firms which then combine to evade tax. By Mr. LAU san-fat

  21. The Firm Supersedes the Market? • R. Coase argues that firms exist because of transaction costs or the ‘cost of using the price mechanism’, including the cost of ‘discovering what the relevant prices are’. • Also including costs: • to discover the other party to deal with, • to negotiate the terms of exchange, • to draw up the contract, • to enforce the contract By Mr. LAU san-fat

  22. The Firm Supersedes the Market? • Without firms, each transaction would involve very high transaction costs in combining many resources through multilateral contracts among all the individual concerned. By Mr. LAU san-fat

  23. The Firm Supersedes the Market? • If these costs are substantial, a factor owner may choose to render his right to use his factor services to a firm in exchange for a proxy payment, which is not an exact measurement of his contributions or marginal revenue product. By Mr. LAU san-fat

  24. The Firm Supersedes the Market? • With firms, the market transactions between consumers and input owners that were originally guided by the price mechanism are replaced by firm transactions as a chain of internal production activities by observing the directions given by the entrepreneur. By Mr. LAU san-fat

  25. The Firm Supersedes the Market? • With firms, the factor market is separated from the product market. • However, without transaction costs, the two markets are inseparable as firms would not exist, a payment made by a customer to the input owner would be the same as a payment made to a product seller. By Mr. LAU san-fat

  26. Product Market Factor Market Cloth-seller Designer A buyer of shirt Firm Cutter Sewer The Firm Supersedes the Market? By Mr. LAU san-fat

  27. The Firm Supersedes the Market? • By forming a firm and allowing authority or an entrepreneur to direct the resources in making transactions for saving certain transaction costs, according to Coase, a firm supersedes the market or a factor market supersedes a product market. By Mr. LAU san-fat

  28. Cheung’s Elaboration • On top of Coase’s argument, Prof Cheung elaborates why it is costly to use the price mechanism without a firm: • First, there is huge contracting costs as the number of transactions are very large. By Mr. LAU san-fat

  29. Cloth-seller Designer A buyer of shirt Cutter Sewer Cheung’s Elaboration • Without firms, the no. of transaction is large: • 1 buyer only: 8 (4 FT + 4 PT) • 3 buyers: 24 (12 FT + 12 PT) By Mr. LAU san-fat

  30. With firms, the no. of transactions is greatly reduced: 1 buyer only: 5 (4 FT + 1 PT) 3 buyers: 7 (4 FT + 3 PT) Cloth-seller Designer A buyer of shirt Firm Cutter Sewer Cheung’s Elaboration By Mr. LAU san-fat

  31. Cheung’s Elaboration • Second, without firms, the information cost in knowing each and every part of a product tends to be significantly high. • With firms, the entrepreneur acts as a specialist agent in contracting with the input owners at lower transaction costs. • Consumers thus bear less cost in knowing the whole product instead of recognizing the value of each component part. By Mr. LAU san-fat

  32. Cheung’s Elaboration • Third, the measurement cost will be prohibitively high in a transaction if the attributes of the product are complicated, if the production activities change frequently or vary extensively. • To be more economical, a proxy will be used by a firm to replace direct measurement of these activities. By Mr. LAU san-fat

  33. Cheung’s Elaboration • Four, the contribution of each input owner may not be easily delineated in doing collaborative or team work and thus some may claim more than is deserved. • With firms, the entrepreneur pays each input owner a price by a proxy on a take-it-or-leave-it basis instead of measuring exact contribution. By Mr. LAU san-fat

  34. Do We Need a Mega Firm? • As argued by Cheung, firms exist to reduce the transaction costs in using the price mechanism, should we build a mega firm to organize all production activities? By Mr. LAU san-fat

  35. Do We Need a Mega Firm? • Coase observes that when the firm expands the entrepreneur becomes less efficient and its extra costs of organizing extra transactions increase. • Thus, the firm will expand until at the margin, the costs of organizing within the firm will be equal either to the cost of organizing in another firm or to the costs involved employing the price mechanism. By Mr. LAU san-fat

  36. The Nature of the Firm • Consider the case that a worker joins a factory/firm and is paid exactly according to the output he or she produces (using the price mechanism). Is the production organized by the firm or through the price mechanism? By Mr. LAU san-fat

  37. The Nature of the Firm • Cheung argues that instead of saying the firm supersedes the market, or the factor market supersedes the product market, it is more accurate to say that one type of contract supersedes or replace another type. By Mr. LAU san-fat

  38. The Nature of the Firm • Firms would choose among different types of contracts and adopt the one with least transaction costs, thus the choice of organizational arrangements is actually a choice of contractual arrangements. By Mr. LAU san-fat

  39. The Nature of the Firm • Cheung further argues that it is futile to determine what a firm is or what optimal size a firm should be as it is often impossible to draw a clear dividing line separating one organization from another when multilateral contracts are allowed among many different market participants. By Mr. LAU san-fat

  40. Contractual Arrangements • Firms would choose among different types of contracts and adopt the one with least transaction costs, thus the choice of organizational arrangements is actually a choice of contractual arrangements. • The choice of contractual arrangement could be explained with the assumptions of non-zero transaction costs and risk aversion. By Mr. LAU san-fat

  41. Wage/Time Rate Contract • Time rate contract is suitable if the quality of product is important • It is not suitable for the worker is his or her product cannot be easily standardized or measured. By Mr. LAU san-fat

  42. Wage/Time Rate Contract • Advantage: • The pricing and measuring costs could be saved as the worker is paid by a proxy rather than the exact amount he or she produces. • Disadvantages: • The worker tends to shirk or to reduce his or her working intensity or output quantity. • Higher monitoring costs involved By Mr. LAU san-fat

  43. Piece Rate Contract • Piece rate contract is preferred if the component of a product can be easily standardized or measured, or when the task performed by the work is repetitive and does not vary frequently. • It will be adopted if the cost of measuring the contributions by each individual is not significant. By Mr. LAU san-fat

  44. Piece Rate Contract • Advantages: • The quantity shirking problem could possibly be avoided • Monitoring cost could then be saved • Disadvantage: • The worker tends to rush and neglect the product quality, resulting in quality shirking problem By Mr. LAU san-fat

  45. Rental or Fixed Rent Contract • Advantage: • The shirking problem could be eliminated as the worker will work harder for maximizing the residual incomes after paying fixed rents for the use of other inputs. • Disadvantages: • Monitoring costs involved in examining the inputs provided by other input owners • The depreciation rate and maintenance cost will be higher By Mr. LAU san-fat

  46. Share Contract • Share contract refers to the contractual arrangement that an agreed proportion on output is shared between the parties involved. • Advantage: • Production risk could be shared • Disadvantages: • The pricing and measuring costs, and the monitoring costs involved are higher than that of other contractual arrangements. By Mr. LAU san-fat

  47. Gratuities or Tips • Advantages: • Providing the employees with an incentive to perform well • The employer has less to lose if the worker does poorly, i.e. risk could be shared • Information costs could be saved in assessing the worker’s performance by checking with amount of the tips one earns. • Monitoring costs could be saved as the customer would monitor the worker for the employers By Mr. LAU san-fat

  48. Outright Sale or Purchase • Suitable for non-human resources • If the monitoring costs involved in using the asset are high or the assets depreciate quickly or policing and enforcing its maintenance are costly, the owner may prefer outright sale to rental contract. By Mr. LAU san-fat

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