Presentation on theme: "EA Session 5: July 11th, 2007 Prof. Samar K. Datta"— Presentation transcript:
1 EA Session 5: July 11th, 2007 Prof. Samar K. Datta Firm & ProductionEA Session 5: July 11th, 2007Prof. 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 firmHandling separation between ownership and controlTechnology & production functionClassification of inputs & isoquantsProduction with one variable input (labor): Relation between AP & MPProduction with two variable inputs & diminishing MRTSReturns to scaleSome applications
3 Why does a firm exist? (not part of reading though) Answers provided by various economistsCoase (highlighting inside vs. market transaction)Choice of the least transaction-cost contractual arrangement to supply the commodityNegotiating with a representative of a coalition of resource owners (firm) for the complete commodityNegotiating with a large number of unitary firms for each component and assemblage of the commodityAlchian & Demsetz (shirking under team production)Impossible to measure marginal product of each member of the teamCreates incentive to shirk (reduce work effort without proportional reduction in income)To prevent shirking, members hire central agent to monitor themselvesMonitor 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 chanceDue to decreasing returns from supervision, the one whose contribution to common effort is the most difficult to measure will assume the role of entrepreneurAsymmetric information about entrepreneurial activity gives strategic advantage to entrepreneurMeasurement 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 sellersOwnership of specialized products or detailed long-term contracts are used to prevent problems of opportunistic bargainingFormalized structure of a firm is the specialized asset in this caseTherefore, 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 inEither 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 corporationM (multi-divisional) form or U (unitary) formHow to manage separation between ownership and controlIncentive-disincentive structureMarket for managersMarket for takeoverFinancing of the firm – debt/equityGrowth of the firmOrganic (till marginal benefits, i.e. reduction in transaction costs, of internalizing an additional activity equal the marginal costs, i.e. increase of agency costs)InorganicMerger / AcquisitionVertical merger (value-addition through byproduct use)Horizontal merger (economies of scope through co-management of related products)
8 Possible objectives of the firm Profit maximizationSales maximizationGrowth maximizationEmployment generationSatisficing behaviorIn 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 processProduction 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) Capitalper yearE5Isoquants showing all possible combinationsof inputs that yield the same output43ABC2Q3 = 90DQ2 = 751Q1 = 5512345Labor per year14
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.OutputperMonthOutputperMonthD11230CE2060B10ALaborper MonthLaborper Month123456789101234567891023
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 OutputpertimeperiodO2BLabor productivitycan increase if thereare improvements intechnology, even thoughany given productionprocess exhibitsdiminishing returns tolabor.CO3100AO150Labor pertime period1234567891037
15 Marginal Rate of Technical Substitution Q1 =55Q2 =75Q3 =90Capitalper year5122/31/3Isoquants are downwardsloping and convexlike indifferencecurves, indicating declining MRS.432112345Labor per month60
16 Isoquants When Inputs are Perfectly Substitutable CapitalpermonthQ1Q2Q3ABCLaborper month64
17 Fixed-Proportions Production Function: Inputs are perfect complements K1Q1Q2Q3ABCCapitalpermonthLaborper month66
18 Increasing Returns to Scale The isoquants move closer together51024ACapital(machinehours)102030Reasons:Larger output associatedwith lower cost (autos)One firm is more efficientthan many (utilities)Labor (hours)75
19 Constant Returns to Scale 102030Capital(machinehours)1551024A6Constant Returns:Isoquants are equally spaced because:Size does not affect productivityMay have a large number of producersLabor (hours)75
20 Decreasing Returns to Scale Capital(machinehours)51024A102030Decreasing Returns:Isoquants get furtherapart due to:Decreasing efficiency with large sizeReduction of entrepreneurial abilitiesLabor (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 resources4) Environmental regulations45
23 Co-existence of large & small units in the carpet industry Economies of scale seem to be favoring larger unitsAdvantages of product diversification as supported by market segmentation favoring smaller units