1. EA Session 5: July 11th, 2007 Prof. Samar K. Datta
Firm & Production
EA Session 5: July 11th, 2007
Prof. Samar K. Datta

2. Overview Why does a firm exist? Internal organization of the firm
Decision to buy (subcontracting) or to make (internalization/ integration)
Internal organization of the firm
Handling separation between ownership and control
Technology & production function
Classification of inputs & isoquants
Production with one variable input (labor): Relation between AP & MP
Production with two variable inputs & diminishing MRTS
Returns to scale
Some applications

3. Why does a firm exist? (not part of reading though)
Answers provided by various economists
Coase (highlighting inside vs. market transaction)
Choice of the least transaction-cost contractual arrangement to supply the commodity
Negotiating with a representative of a coalition of resource owners (firm) for the complete commodity
Negotiating with a large number of unitary firms for each component and assemblage of the commodity
Alchian & Demsetz (shirking under team production)
Impossible to measure marginal product of each member of the team
Creates incentive to shirk (reduce work effort without proportional reduction in income)
To prevent shirking, members hire central agent to monitor themselves
Monitor has low incentive to shirk as he gets a claim on the firm’s residual income

4. Why does a firm exist? (not part of reading though)
Barzel (highlighting measurability problem)
Environment characterized by costly information and outcomes affected by chance
Due to decreasing returns from supervision, the one whose contribution to common effort is the most difficult to measure will assume the role of entrepreneur
Asymmetric information about entrepreneurial activity gives strategic advantage to entrepreneur
Measurement problem solved by assigning entrepreneur a claim on the residual value of the joint venture.
Williamson (highlighting role of specialized assets to conduct transactions – need to vest residual control and residual claim right on a single party)
A specialized or custom-made product has asset specificity, which is vulnerable to opportunistic behavior by both buyers and sellers
Ownership of specialized products or detailed long-term contracts are used to prevent problems of opportunistic bargaining
Formalized structure of a firm is the specialized asset in this case
Therefore, the least transaction cost alternative is chosen

5. Why are capitalists the bosses?
Who has got the maximum stake in the production process/system?
With respect to whose efforts is there the maximum information failure problem?
Which factor of production is a co-specialized asset along with the firm – land, labor, capital or the capitalist-entrepreneur?

6. Why does a firm exist?
Two broad conditions, as cited by Dholakia & Oza:
Q (x, y) ≥ Q (x) + Q (y),
or, C (x, y) ≤ C (x) + C (y)
2. TC (x, y) ≤ TC (x) + TC (y)
Economies of scope thus working in terms of saving in
Either transformation costs (i.e., costs of inputs, which enter directly into the production process)
Or transaction costs (i.e., costs of coordination & monitoring of inputs directly entering into the production process)

7. Internal organization of the firm
Unitary, partnership, or corporation
M (multi-divisional) form or U (unitary) form
How to manage separation between ownership and control
Incentive-disincentive structure
Market for managers
Market for takeover
Financing of the firm – debt/equity
Growth of the firm
Organic (till marginal benefits, i.e. reduction in transaction costs, of internalizing an additional activity equal the marginal costs, i.e. increase of agency costs)
Inorganic
Merger / Acquisition
Vertical merger (value-addition through byproduct use)
Horizontal merger (economies of scope through co-management of related products)

8. Possible objectives of the firm
Profit maximization
Sales maximization
Growth maximization
Employment generation
Satisficing behavior
In the long-run, no firm can ignore profit considerations. Hence, profit maximization often looked upon as a reasonable description of firm behavior in reality.

9. The technology of production
Production Process: Combining inputs or factors of production (land, labor, capital, organizational skill) to achieve an output, i.e., the transformation process
Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs, given the state of technology.
Shows what is technically feasible when the firm operates efficiently.

10. The Isoquant Map: Production with Two Variable Inputs (L,K)
Capital
per year E 5
Isoquants showing all possible combinations
of inputs that yield the same output 4 3 A B C 2
Q3 = 90 D
Q2 = 75 1
Q1 = 55 1 2 3 4 5
Labor per year 14

11. Importance of time period
Short-run:
Period of time in which quantities of one or more production factors cannot be changed.
These inputs are called fixed inputs.
Long-run:
All inputs are variable in the long run; so there are no fixed inputs. 16

12. Production with One Variable Input (Labor): Relation between AP & MP
AP = slope of line from origin to a point on TP, lines b, & c.
MP = slope of a tangent to any point on the TP line, lines a & c.
Output
per
Month
Output
per
Month D
112 30 C E 20 60 B 10 A
Labor
per Month
Labor
per Month 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 23

13. Law of Diminishing Marginal Returns
When the labor input is small, MP increases due to specialization (better utilization of fixed inputs).
When the labor input is large, MP decreases due to inefficiencies (fixed factors become limited in supply). 32

14. Effect of Technological Improvement
Output
per
time
period O2 B
Labor productivity
can increase if there
are improvements in
technology, even though
any given production
process exhibits
diminishing returns to
labor. C O3
100 A O1 50
Labor per
time period 1 2 3 4 5 6 7 8 9 10 37

15. Marginal Rate of Technical Substitution
Q1 =55
Q2 =75
Q3 =90
Capital
per year 5 1 2
2/3
1/3
Isoquants are downward
sloping and convex
like indifference
curves, indicating declining MRS. 4 3 2 1 1 2 3 4 5
Labor per month 60

16. Isoquants When Inputs are Perfectly Substitutable
Capital
per
month Q1 Q2 Q3 A B C
Labor
per month 64

17. Fixed-Proportions Production Function: Inputs are perfect complementsK1 Q1 Q2 Q3 A B C
Capital
per
month
Labor
per month 66

18. Increasing Returns to Scale
The isoquants move closer together 5 10 2 4 A
Capital
(machine
hours) 10 20 30
Reasons:
Larger output associated
with lower cost (autos)
One firm is more efficient
than many (utilities)
Labor (hours) 75

19. Constant Returns to Scale10 20 30
Capital
(machine
hours) 15 5 10 2 4 A 6
Constant Returns:
Isoquants are equally spaced because:
Size does not affect productivity
May have a large number of producers
Labor (hours) 75

20. Decreasing Returns to Scale
Capital
(machine
hours) 5 10 2 4 A 10 20 30
Decreasing Returns:
Isoquants get further
apart due to:
Decreasing efficiency with large size
Reduction of entrepreneurial abilities
Labor (hours) 75

21. Application: Malthus and the Food Crisis
Why did Malthus’ prediction fail?
Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand.
Technology has created surpluses and driven the price down.
Question: If food surpluses exist, why is there hunger?
The cost of distributing food from productive regions to unproductive regions and the low income levels of the non-productive regions. 40

22. Example: Explanations for Productivity Growth Slowdown
1) Growth in the stock of capital (both human and non-human) is the primary determinant of the growth in productivity.
Rate of capital accumulation in the U.S. was slower than other developed countries because the others were rebuilding after WWII.
3) Depletion of natural resources
4) Environmental regulations 45

23. Co-existence of large & small units in the carpet industry
Economies of scale seem to be favoring larger units
Advantages of product diversification as supported by market segmentation favoring smaller units