Lecture 11 Economic Theory of the Firm

1. Lecture 11Economic Theory of the Firm There are two views of the firm: 1. Neoclassical (traditional) theory: • Firm is a calculating entity, that makes decisions, buys inputs, making output, and selling for profit for loss 2. Property rights theory: • Firm is a collection of contracts between owners of resources, who wish to combine portions of their resources, for some period, for some purpose

2. Traditional Theory of the Firm • Traditionally, the firm — headed by the entrepreneur or manager — makes decisions: • What to produce? • When and how to produce it? • How much to produce? • What is its price? • The firm is seen as having a production function: • Relates inputs and outputs — like a recipe • q = q (x,y,z) • q is output • x, y, z are inputs • The exact form depends on technology, etc.

3. A production function • A production function is often a mechanical view of production: • 1 shovel of cement • 3 shovels of sand • 5 shovels of stone • 4 liters of water • Use labor to mix cement, sand, and stone for 1 minute • Add more water to get right texture • Use labor to mix ingredients for 2 minutes • Output: 12 liters of wet concrete Most of this is engineering. The role of economics is limited to the importance of price, substitutes, etc. Important concepts, but not difficult to grasp.

4. Property Rights Theory: Firms and Markets The tradeoff: • Market is informationally efficient • The firm is contractually efficient • The balance between these two determines the methods of production chosen by an entrepreneur or manager

5. What Kind of Organizational Form to Choose? A key role of managers is to procure inputs in the least cost manner. If not accomplished, costs will be higher than needed and the firm will lose profits and perhaps go bankrupt. Basic Question: To achieve greater efficiency, does a manager procure inputs from the market or procure inputs within the firm?

6. How to obtain needed inputs? Consider possible stages of production: Obtaining raw materials Obtaining finished parts Assembly Transportation services Storage Wholesaling Retailing

7. How to obtain needed inputs? General services needed by a firm: Accounting Finance (including credit service) Human Resources Legal Services Marketing (advertising, etc.) Janitorial Service Who is to provide such services?

8. Who provides needed services and materials? • Should the firm produce within the organization or buy from the outside? • There is no one answer—many conditions will determine outcome. • Think of the great range of options: Spot markets → Long Term Contracts → Vertical Integration (produce in house)

9. Methods of Obtaining Inputs 1. Spot market or spot exchange— Buyers and sellers exchange, but might not deal again. Benefit: deal with specialized sellers, usually low transaction costs. The provider is not integrated into the firm. Possible problem: exploitation by seller who knows we are ignorant or inconsistent quality.

10. Methods of Obtaining Inputs 2. Contracts— Legally based extended relationship between buyer and seller. Benefits: specialization; ability to terminate sellers who do not perform; reduction in exploitation compared to spot markets. Problems: costly in complex environments; incentives to act badly.

11. Many Forms of Contracts • Services (Deere and Ryder Trucks; UPS and Toshiba warranty laptop repairs; UPS and Jockey; Japanese call centers in Dalien) • Joint Ventures (foreign firms in China) • Leases (office buildings) • Franchises (McDonalds, car dealers) • Strategic Alliances (Merck & Astra)

12. Methods of Obtaining Inputs 3. Vertical Integration— (Non-market relations) When a firm chooses to produce an input internally rather than contract with outsiders. Benefits: reduced opportunistic behavior by outsiders and fewer contracting costs. Problems: lost specialization and increased organizational (managerial) costs.

13. When Is Vertical Integration Most Likely to Be Necessary? To protect brand name (goodwill) protection Examples: Sony, Prada, Ralph Lauren When there are specific assets or high sunk costs or contracts hard to enforce. Examples: pipeline; GM-Fisher

14. Methods of Obtaining Inputs Summary: Are there specialized investments relative to contracting costs? If no—likely to use spot market. If yes—is the cost of contracting high relative to the cost of integration? If yes—vertical integration; if no—contracts with outside suppliers. Think about chickens.

15. Recent Example: Ford • Ford used annual bidding competition to achieve low cost suppliers for auto parts ($7 billion a year). • Problems: high administrative cost, bankruptcy by suppliers (Delphi), quality control uneven • Solution: multi-year contracts with fewer suppliers (down from 2,500 to 1,000); closer working relationship; estimated savings of 10% per year.

16. Agency Costs • Employees or contractors not behaving as they should — is a part of what we call Agency Costs or Agency Problems. • Agency costs exist as a problem whenever a principal hires an agent to act on his behalf. • Solving this universal problems is a key managerial problem in managing personnel and in controlling costs.

17. A Major Drawback of Firms: Agency Costs Agency costs arises from the separation of ownership and control. Owners of firms are interested in profit maximization. Managers, employees, and suppliers are interested in maximizing their own self-interests. How do we give employees incentives to act as if they were owners of the firm? How do we get employees to not shirk—that is, work as hard as they can in the manner the owners would want? It is a matter of incentives.

18. Agency Costs . . . • These are a problem because we are human. If we “cheat” ourselves, then no one else bears the cost. So the one-person firm is efficient and does not suffer agency costs. • It is natural for us to want to exploit others: get others to pay more than they agreed to pay or we produce less than we agreed to produce. That is, a divergence in interest between principal and agent in a multi-person organization and in contracts.

19. Monitoring We have incentives to shirk – take more than we should or work less than we should. Monitoring is costly, so sensible to accept some losses. Many forms of monitoring exist (spot checks, etc.). Usually there is unequal (asymmetric) information between parties. One knows more than the other and can exploit that. Examples: Person selling used car. Buy insurance (buyer exploits seller)

20. Monitoring, Bonding & Signals • How do we assure customers that we can be trusted, so they should contract with us? Various devices: Fixed price contracts; Bonds; Warranties; Future price guarantees. Less formal: Reputation. This matters greatly in the market. We pay premiums to deal with firms with good reputations.

21. Entrepreneurs and their Firms • Key Managerial Problem: Giving employees incentives to act as if they are owners. The entrepreneur or top manager must cede authority to others. The issue is: How do we structure an organization to reduce agency costs? The movement has been in this direction; especially in knowledge-based production.

22. Decentralization: Pros & Cons • Empowering workers and managers. BENEFITS: 1. More effective use of local knowledge — those closest know the most 2. Conservation of senior management — top people cannot know or do everything 3. Training & motivation for local managers: helps attract and keep good managers and train future top managers

23. Decentralization . . . Empowering workers and managers: COSTS: 1. Agency costs— shirking; self-dealing — so control and monitoring measures needed 2. Coordination costs and failures — duplication; pricing errors 3. Less effective use of central information— local managers cannot know all information the central managers here, so have inferior knowledge

24. Team Production: Increasing or Decreasing Costs? Create teams of people with different expertise to make decisions— Ex.—Hallmark Cards had teams of art, design, production and marketing assigned by holiday with decision rights rather than move produce from functional area to area—cut time in half. Benefits—Improved use of specific knowledge and employee “buy in” due to better information, more cooperation & less blame. Costs—Collective-action and free-rider problems. Same thing in car production—team development tried at Chrysler; separate functional areas at GM. Tradeoffs.

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

26. Questions: How Do We Overcome Agency Costs? • The larger the organization, or the greater the distance from the owners to the workers, the more likely that agency costs will become significant —large corporation look more like an inefficient government agency. What economic incentives do firms take to try to give workers proper incentives? What about ESOPs? Compensation schemes?

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

28. Question on Team Incentives • Suppose different numbers of people are assigned to pull a rope “as hard as you can.” • One person pulls the rope. • Three people pull the rope together. • Eight people pull the rope together. • How does the pulling force (work effort) per person change across these three cases?

29. Incentives of Managers • In the fast-food industry, about 30% of stores are company owned and run by a salaried manager. About 70% of the stores are run as franchises by owner-operators who split profits with the parent company. 1) Which kind of store would you think would tend to be more profitable? 2) Why then does the parent choose to own some? Where would they be located? 3) Would you expect employees to see a difference in the managers?