1 Coase, Theory of the Firm, Tirole chapter 0 Eric Rasmusen, G604, Tirole-Coasle, size of firms, march 28, 2006

2 Classics: Organization R. H. Coase (1937) "The Nature of the Firm," Economica, New Series, 4, 16: (November 1937) Classics: Organization R. H. Coase (1937) "The Nature of the Firm," Economica, New Series, 4, 16: (November 1937)R. H. Coase "The Nature of the Firm,"R. H. Coase "The Nature of the Firm,"

3 Coase (1937)

4 Transaction Costs

5 Using Marginalism

6 Master and Servant The last part of Coase is about authority. The principal commands the agent. The last part of Coase is about authority. The principal commands the agent. Why is the principal the entrepreneur and not the worker? (not in Coase) Why is the principal the entrepreneur and not the worker? (not in Coase) Why does the residual claimant have the authority? (not in Coase) Why does the residual claimant have the authority? (not in Coase)

7 Tirole Top person in theoretical IO, Id say. He writes books a lot. Toulouse, MIT. Top person in theoretical IO, Id say. He writes books a lot. Toulouse, MIT. p. 20. Why do economies of scale have to be exploited within the firm? p. 20. Why do economies of scale have to be exploited within the firm? This relates to Coase (1937) This relates to Coase (1937)

8 Why Not One Big Firm? Williamsons Puzzle of Selective Intervention: why not merge two firms and then manage them just the same as before? (p. 21) One answer: we cannot contract to make the CEO of each firm a residual claimant. Think of Holmstroms Teams model (1982). Rasmusen and Zenger, ``Diseconomies of Scale in Employment Contracts,'' Journal of Law, Economics and Organization (June 1990), 6(1): Rasmusen and Zenger, ``Diseconomies of Scale in Employment Contracts,'' Journal of Law, Economics and Organization (June 1990), 6(1):

9 Bargaining Power (Rasmusen) Two possible meanings: 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets 3) 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets 3) 2. The division of surplus (Apex gets 100%, Brydox gets 0%) vs. (Apex gets 20%, Brydox gets 80%)

10 Bargaining: Why the Coase Theorem Breaks Down (pp ) (2) Nature chooses buyer value v using density f(v) on [a,b] with seller cost c in (a,b). The buyer observes this. (3) The seller offers price p to the buyer. (4) The buyer accepts or rejects. This leads to inefficiency–-the Myerson-Satterthwaite problem. Seller proposing an offer at (1) would not help. Merging at (1) would help. So we should put buyer and seller in the same firm. OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism (footnote 29) OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism (footnote 29)

11 Asset Specificity/The Hold-Up Problem (p. 24) (1) The buyer value is v=3. The seller can invest 2 to get c=0 or not invest, to keep c=4. (2) The buyer offers price p to the seller. (or, use split) (3) The seller accepts or rejects. This leads to investment of 0. The buyer proposing an offer at (0) *would* help. Merging at (0) would help too. So we should put buyer and seller in the same firm. OR: give all the bargaining power to the investing party, i.e. the seller here. OR: give all the bargaining power to the investing party, i.e. the seller here.

12 Asset Specificity/The Hold-Up Problem Example (p. 28) Joskow found that when coal quality is diverse, not many transportation methods, and few mines, then long- term contracts will be used (West US) In the opposite case, short-term contracts (spot markets) are used (East US)

13 Authority (p. 30) Authority changes the threat point in bargaining. It changes, in a sense, bargaining power. Authority changes the threat point in bargaining. It changes, in a sense, bargaining power. Think of the UN Security Council. Suppose Russia and France do not care about Rwanda policy, but the US does. Is the effect of giving them veto power over US policy to change US policy? Think of the UN Security Council. Suppose Russia and France do not care about Rwanda policy, but the US does. Is the effect of giving them veto power over US policy to change US policy?

14 Unconstrained Bargaining (pp ) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2) The buyer value of the new feature is v>c with probability x and 0 otherwise. (3) Buyer and seller bargain for a price p for the feature. If they disagree, the new feature is not added to the product. Assume: bargaining splits the gains from agreement. Result: Underinvestment

15 Seller Has Authority to Make Changes ( p. 32) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with probability x and 0 otherwise. (2.5) The seller decides whether to add the new feature to the product. (3) Buyer and seller bargain for a price p for the feature. The feature is added only if the seller agrees to add it. Assume: bargaining splits the gains from agreement. Result: Underinvestment

16 Buyer Has Authority to Make Changes ( pp ) (0) The buyer and seller have made a basic contract. (0) The buyer and seller have made a basic contract. (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with probability x and 0 otherwise. (2.5) The buyer decides whether to add the new feature to the product. (3) Buyer and seller bargain over whether the new feature is to be added. The decision is ultimately up to the buyer. Assume: bargaining splits the gains from agreement. Result: Overinvestment

17 What if the New Feature Might Be Actually a Negative? We can run that model with probability x of value v>c and probability (1-x) of value –y c and probability (1-x) of value –y<0 too. Then, buyer authority does not result in overinvestment, I think--- for reasons elucidated in Lyon and Rasmusen, Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,' Journal of Law, Economics and Organization, 20,1: (April 2004)Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'

18

19 A link to the course website