1. The Economics of Business
Class 2 Notes
Harvard Extension School
Instructor: Bob Wayland
Teaching Assistant: Natasha Wambebe

2. Revisit Class 1
What are the four foundations of our foundation as found in Adam Smith’s Wealth of Nations?
What is the primary driver of economic wealth?
What is necessary to realize the benefits of specialization?
How are economic and biological systems similar?
Outline incomplete without oral presentation

3. Revisit Class 1… What distinguishes positive from normative economics?
What characteristic of using markets did Coase suggest stimulated the emergence of firms?
What change in the characteristics of the U.K. textile industry before and after the industrial revolution illustrate Coase’s argument? 
What factors, ceteris paribus, tend to increase firm size? 
What factors did Coase suggest lead eventually to constraints on the size and scale of firms?
What determines the ultimate limit to firm size, how does this relate to the concepts of variable proportion diminishing marginal returns?
Outline incomplete without oral presentation

4. Alchian and Demsetz, Production, Information Costs, and Economic Organization
Alchian and Demsetz expounded on the importance of cooperation as an explanation of firms
Productivity increases through cooperative, team based production 
Demand for organizations to facilitate that cooperation 
More detailed picture than Coase, sought to:
Explain the conditions when cooperative specialization benefited from organization or market
Explain the structure of the organization
Outline incomplete without oral presentation

5. Alchian and Demsetz, continued
Argued that Coase overstated power of hierarchy over market
Firms do not own all of their resources
Power to deploy and discipline no greater than through market 
Fundamental basis for firms is superior ability to organize cooperative efforts 
Cooperative activities (teams) are difficult and costly to meter (manage)
Joint, combined, simultaneous individual efforts 
Specialized knowledge and careful observation required to meter joint or team effort
Outline incomplete without oral presentation

6. Alchian and Demsetz
A team production function: z = f(x,y) is described mathematically by non-zero second cross partial derivatives: ∂f2/∂x∂y ≠ 0.
E.g. if z = f(x,y) = x3 + x2y3 -2y2 , then
fx = 3x2 + 2xy3, and  
fxfy =∂/∂y (3x2 + 2xy3) = 6xy2 for all x,y ≠ 0
But, if z = f(x,y) = x3 – 2y2 then 
fx = 3x2 , and
fxfy = ∂/∂y (3x2) = 0
Note: This is a little warm-up or warning shot exercise. If you find this incomprehensible your calculus is probably not up to dealing with some future articles such as Klepper
Outline incomplete without oral presentation

7. Alchian and Demsetz, continued
Team production makes shirking difficult to observe
Person more prone to shirk as a team member than in task involving separable work
Shirker gains all of leisure
Shirker sacrifices 1/n of reward
Manager seeks to minimize shirking subject to costs of metering (optimal level of shirking)
Outline incomplete without oral presentation

8. Alchian and Demsetz, continued
Firm (or principal) is the common contracting party for all team members
Manager has claim on the residual value created by the team
Centralized contracting is important characteristic of firm
Reduces re-contracting costs
Promotes familiarity and knowledge to better observe and counteract shirking
Outline incomplete without oral presentation

9. Alchian and Demsetz, continued
The classical firm* is defined as a contractual structure with:
Joint input production;
Several input owners;
One party who is common to all the contracts of the joint inputs who
Has rights to renegotiate any input's contract independently of contracts with other input owners;
Holds the residual claim; and
Who has the right to sell his central contractual residual status.
The central agent (principal) is called the firm's owner and/or the employer
*”Our exposition also suggests a definition of the classical firm –something crucial that was heretofore absent.” (p784) I am unclear on exactly how they can “retroactively” define a classical firm.
Outline incomplete without oral presentation

10. Alchian and Demsetz, continued
Alchian and Demsetz see limits to scale of the firm consistent with Coase but more specific than simply a “generic” recourse to diminishing returns to management.
The greater the interdependencies among functions, and the needs for specialized knowledge to manage those interdependencies, the more important is centralized contracting
The larger a firm and the more different bodies of knowledge it must master to manage interdependencies, the more difficult and expensive it becomes to perform efficiently.
Keep these points in mind when we discuss Simon and the limits to human cognitive powers
Outline incomplete without oral presentation

11. Alchian and Demsetz, continued
Firm type defined by residual sharing arrangements
Profit Sharing Firms
Socialist Firms
The Corporation
Mutual and Non-profit Firms
Partnerships
Employee Unions (not firms but monitoring service)
Outline incomplete without oral presentation

12. Alchian and Demsetz, continued
Profit sharing firms are generally found in small team size settings
Facilitates self-policing for small teams (non-specialized monitoring)
Under equal profit sharing schemes incentives to shirk directly related to the size of the team
Within large firms, equal sharing diffuses incentives of management
Outline incomplete without oral presentation

13. Alchian and Demsetz, continued
Socialist firms often marked by broad sharing of residual value (if any)
Managers have no special claim on residual, lack incentive
Proxies for residual; e.g. goals, evaluations, etc. used
Worker evaluations, where used, may encourage tolerance of shirking
Outline incomplete without oral presentation

14. Alchian and Demsetz, continued
Corporations are marked by diffuse ownership
Small shareholders have little incentive to meter
Liquidity limits risk
Managers are policed to some extent by
Internal competition
Potential change of ownership (raiders, LBOs, etc)
Perhaps better to view stockholders as investors, not owners (How would the SEC react to this?)
Outline incomplete without oral presentation

15. Alchian and Demsetz, continued
Mutual and non-profit firms
No market valuation
Often compensated on “comparable” basis
Rewarded for “inputs’
Outline incomplete without oral presentation

16. Alchian and Demsetz, continued
Partnerships
Frequently for jointly produced artistic and intellectual productions
Small scale permits self-policing
Often formed among relatives or friends
Once common in “professional services” but replaced by LLCs to limit liability
Outline incomplete without oral presentation

17. Alchian and Demsetz, continued
Employee unions
Not firms, usually don’t create tradable products and services
Do provide monitoring services for members
Some provide training, hiring hall, and insurance services
Serious agency problems with respect to members in some cases
Outline incomplete without oral presentation

18. Alchian and Demsetz, continued
Input ownership
Ownership resides where expected returns are greatest
Asset ownership arrangements are very similar to share-cropping contracts – basic form of risk-sharing contracting
Costs of asset use include depreciation and loss of service due to carelessness
Outline incomplete without oral presentation

19. Alchian and Demsetz, continued
Firms will own those assets they can economically apply and monitor (owner absorbs financial and physical depreciation)
Centralized monitoring of abuse worthwhile for expensive physical assets
Typically owned by company
May be rented if cost, including premium for expected abuse, is lower than ownership costs
Later, asset ownership was viewed as a means to avoid “hold-up” and to exercise control over users
Outline incomplete without oral presentation

20. Alchian and Demsetz, continued
Employees will own assets if best able to realize the value of their service and protect them from abuse
Workman can more easily monitor abuse of his tools
Dedicated assets, even trucks, often employee owned
Specialized tools of the trade, frequently owned by workers
Outline incomplete without oral presentation

21. Alchian and Demsetz, continued
Firm as a Specialized Market Institution for Collecting, Collating, and Selling Information
Firm can be considered a “private market”
Nuanced contrast to Coase “substitute”
Firm is in position to evaluate and direct resources better than those resources could on their own
Resources may find it better to work (sell their services) within a private market (firm) than through the public markets
Analogous to the private market of a department store
Efficient production with heterogeneous inputs
Not always better resources
Better knowledge about those resources
Combinations of resources
Adjustments in prices
Do public markets suffer from communal ownership?
Outline incomplete without oral presentation

22. Harold Demsetz, The Theory of the Firm Revisited
Follow-up to earlier work with Alchian
Observes need for greater emphasis on information in explaining firms
Describes the failure of “perfect decentralization” model to explain firms
Discusses some problems with TCE
Identifies the need to consider both transactions and production cost across internal and external options (later addressed by Williamson)
Notes that output or the producing firm may be purchased, need to clarify the relevant transactions costs
Traces confusion to lingering notion of free information
Outline incomplete without oral presentation

23. Harold Demsetz, Revisited…
Moral Hazard, Shirking and Opportunism
Attention turned to incentive alignment
Dealing with moral hazard involves costs
Close ties between asset specificity and opportunism
Firm-like production results in a special form of productivity
Outline incomplete without oral presentation

24. Harold Demsetz, Revisited…
Firm-Like Organization
“The firm properly viewed is a ‘nexus’ of contracts.”
Questions involve:
The persistence of certain types of contracts
The variation in other types of contracts that are “more-or-less” included in the nexus
The (horizontal and vertical) scope of activities covered by these contracts
We have now the tensions among forces shaping relationships
Specialization (idiosyncrasy) increases productivity but also vulnerability
Cooperative, team-based output (through either firm or contract) to achieve benefits of specialization
Human nature gives rise to moral hazard, opportunism, shirking, etc. and requires management
Outline incomplete without oral presentation

25. Title is borrowed from Adam Smith’s observation
George Stigler, The Division of Labor is Limited by the Extent of the Market
Title is borrowed from Adam Smith’s observation
Ricardo, Senior, and J.S. Mill observed the phenomenon of industrial increasing returns
Dilemma: If further division of labor continuously lowers costs for larger outputs entrepreneurs would expand and monopolize industries
Decreasing cost functions and increasing returns to scale were troublesome concepts and neglected
In 1928 Allyn Young re-emphasized Smith’s theorem but couldn’t successfully integrate into the theory of the firm
Outline incomplete without oral presentation

26. George Stigler, The Division of Labor is Limited by the Extent of the Market…
Stigler observed the “life cycle” of firms from fully vertically integrated to more focused entities and then re-integrating as the industry declined
 An evolutionary concept analogous to species interacting with their environment or habitat (not stated as such by Stigler)
 Firms may be seen as performing a series of distinct (separable) operations
 These operations can be defined in terms of common rates of output and therefore summed vertically
 Highly vertically integrated firms typically engage in operations with various cost curve shapes
Outline incomplete without oral presentation

27. George Stigler, The Division of Labor is Limited by the Extent of the Market…
Outline incomplete without oral presentation

28. George Stigler, The Division of Labor is Limited by the Extent of the Market…
Vertical integration occurs also when the market or price system does not clear at MC of the product and Marginal-Value Product.
Outline incomplete without oral presentation

29. George Stigler, The Division of Labor is Limited by the Extent of the Market…
Outsourcing – think of it as vertical de-integration
Outsourcing is simply buying rather than making – the original Coasian choice
Stigler’s life cycle or evolutionary model can explain some outsourcing
Much (most?) outsourcing is compelled by market forces and not particularly discretionary
Society’s overall wealth increases with the increase in specialization
Some particular people may be hurt
In some “clusters” the existence of a commonly accessible source for decreasing cost operations makes it much easier to start new specialized firms.
Outline incomplete without oral presentation

30. ********************
Next Week
Uncertainty, evolutionary economics, firm selection and survival
Alchian, “Uncertainty, Evolution, and Economic Theory”
Nelson and Winter, “Evolutionary Theorizing in Economics”
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Outline incomplete without oral presentation