Eaton Micro 6e Ch19

7/27/2019 Eaton Micro 6e Ch19

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2005 Pearson Education Canada Inc.19.1

Chapter 19

The Theory of the Firm


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Who Owns the Firm?

Ownership means essentially 3 things:

1. Control of decisions within the firm.

2. Residual claims on the firm.3. The right to sell the rights to the

above.


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Control of Decisions Within the Firm

Control includes deciding whatproducts to make, how to producethem, how to sell them and what

prices to adopt.


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Residual Claims on the Firm.

A residual claimant has the right totake home income from profits(revenues less costs).

Within a firm there may be manytypes of claimants (stock holders,employees with bonuses, etc.).


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The Right to Sell Ownership and

Residual Claims.

Ownership involves the right totransfer the assets of the firm.

Stockholders may have the right tohire and fire a CEO, but not the rightto negotiate capital purchases.


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Figure 19.1 The pattern of ownership


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Three Relationships Between Residual

Claimants and Control of the Firm

1. Owner-operated-The person whomakes the managerial decisionsthat affect the firms profits is the

same as the person who lays claimto that profit.

2. Partnership-The ownership andmanagement functions are jointlyshared by two or more persons whowork in the firm.


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Three Relationships Between Residual

Claimants and Control of the Firm

3. Corporation-Where residualclaimancy is almost totally separatefrom management or control. For

example in publicly heldcorporations residual claimancy isspread over the share holders and

at the same time executivesexercise control within the firm.


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Organizational Forms

The central hypothesis of the moderntheory of the firm is that theorganizational forms that we

encounter every day are the onesthat achieve the closest possibleidentity between the objectives of

the individuals inside the firm andthose of the firm as a whole.


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The Owner-Operator Firm

For simplicity, it is assumed that eachunit of effort generates $1 of income.(yR=eR).

At the equilibrium of the onepersonfirm, the slope of the indifference curve(MRS=the rate at which additional effort

generates additional income) is equal to1. (see Figure 19.2)


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Figure 19.2 Preferences over effort and income


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Figure 19.3 The one-person firm


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A Partnership Alternative

For the two person firm, the sum of theirincomes must equal the effort they jointlyexpend: yR+yV=eR+eV.

One partners income is determined by thefollowing income effort relationship:yR=(eR+eV)/2.

The partnership fails to create the optimal

private incentive because neither partnercan capture the whole added output fromincreasing his/her personal effort.


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Figure 19.4 Shirking in a partnership


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Figure 19.5 The partnership equilibrium


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Pareto-Optimality and the Choice

of Institutions

Modern theories of the firm suppose thata Pareto-optimal organizational form willbe chosen.

An organizational form is Pareto-optimalif there is no other organizational formthat will leave all parties at least as well

off and at least one party better off.


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Team production

Team production is an arrangementin which two or more workersaccomplish a productive task through

joint effort.

When theproductivity gainsassociated with joint product (B) are

large enough, the partnership ispreferred to oneperson firm.


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Figure 19.6 The owner-operated firm


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Owner-Operated Firm

In absence of contracting ormonitoring costs, the owner-operated team is Pareto-preferred to

both the one-person firm and thepartnership.

This notion is illustrated by

comparing equilibriums C and D inFigure 19.6.


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Contracting and Monitoring Costs

Our model will now be extended toinclude costs of entering into contractswith employees and monitoring

employee productivity.Roberta must pay for half the monitoring

costs (M) but can keep all incomegenerated from her effort.

Her income-effort relationship is:

yR=BeR-M/2


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Figure 19.7 The owner-operated firm

with monitoring costs


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Contracting and Monitoring Costs

Given the incomeeffort relationship,Roberta can attain point V in Figure 19.7.

The following contract will allow Roberta

& Victor to attain point V:Victor will receive income Y from Roberta if

he supplies e or more units of effort.

However, if he supplies less than e units ofeffort, he will receive no income.


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Pareto-Optimal Organizational Forms:

Depending upon the productivityadvantage associated with team-work (B) and the costs of monitoring

(M), any one of the threeorganizational forms considered canbe Pareto-optimal relative to the

others.


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Figure 19.8 Pareto-preferred organizational forms


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Specialization and the

Division of Labour

According to Adam Smith (1776), threefactors explain increased productivity fromspecialization and division of labour:

1. Specialized workers are more productive viarepetition (learning by doing).

2. Workers save time by not switching tasks.

3. Specialization encourages technical progress.


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Transaction Costs

A firm will expand to the point atwhich the cost (including transactioncost) of adding another function in-

house is just equal to the cost(including transportation costs) ofcoordinating that function through

the market place.


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Generic Versus Specific Inputs

On one hand, firms have theincentive to buy finished goods asinputs, because they can thereby

avoid the difficulties associated withharmonizing the interests ofindividuals within the firm.


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On the other hand, firms have adisincentive to buy specific inputsfrom other firms because these

inputs are subject to high transactioncosts across markets.


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Whether we find decentralization(coordination of economic activity viamarkets) or centralization

(coordination of economic activitywithin firms) depends upon whetherthe advantages of decentralization

outweigh the resulting contractingcosts.

Eaton Micro 6e Ch19

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