Markets, Firms and Consumers Lecture 2- Theory of the Firm

Lecture Overview Administration – Workshops – Test (Wednesday 5 April) – Assignment Why have a Theory of Firms? What Theories of the Firm exist? The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of the mind. John Maynard Keynes

Why have a Theory of the Firm? Chapter 2… Problem- – Given markets are efficient, why don’t people use market transactions all the time? Coase (1932) Firms coordinate by ‘command’ processes. Answer – Firms experience transaction costs

Transaction Costs Coase Organisations are structured to ‘minimise’ transaction costs. Firms are a way to coordinate and motivate. Coase did not elaborate what transaction costs were.

Types of Transaction Costs Coordination Costs – Arises form the need to determine prices and other details, to make existence and location known, to bring buyers and sellers together. Motivation Costs – Asymmetric information Fear of opportunism – Imperfect Commitment Threats and promises not credible

Dimension of Transactions 1. Specificity of investments required 2. Frequency of transactions and duration over which they are repeated 3. Complexity of transaction and uncertainty over performance 4. Difficulty of measuring performance 5. Connectedness of transaction to others

Neoclassical Theory of the Firm Alchian and Demsetz The problem occurs whenever team production occurs. Team production – Several types of resources are used – The product is not a sum of separable outputs of each cooperating resource – Not all resources used in team production belong to one person This generates shirking problem

Nexus of Contracts The manager/monitor has authority to – Revise contract and incentives of individual members – Without having to revise the whole team This reduces shirking – A Firm allows gains from ‘team production’ to be realised. Manager claims residual.

Applications 1 Marriage – Unusual form of a ‘partnership’ – Contract provides few conditions for dissolution …for richer or poorer …in sickness and in health – Conditions for dissolving contract include cruelty or inability to consummate.

Marriage continued Courts reluctant to intervene in marriage contracts, not reluctant for commercial. What is purpose of ‘locking-in’ two parties – Exploit gains from specialisation/team production – Depends on ‘love’ as motivating/coordinating solution – Produces ‘children’.

Other Organisational Forms Limited Liability Companies – Often large-scale, capital intensive Large amounts of capital have to be raised and committed. Investors need to be able to get money back – Compete with bank contracts Liquidating firm to get money back is inefficient. Liability limited to value of investment.

Partnerships Often involve professionals Limited in size Asset each partner brings is intangible, difficult to monitor (self- monitoring). Firm size is naturally small Note that doctors often hire nurses Nurses don’t form partnerships and hire doctors. Why is this efficient? – Who has most ‘asset specific’ human capital?

Franchises Often involve Fast Food – So not capital intensive – Business has significant number of repeat consumers – Organised with many routines

Intermediated lending Often occurs with banks – Banks take a large number of small deposits – Convert into large loans – Deposits gathered by deposit contracts (payable on demand) – Loans have different maturity profile and size – Banks may have comparative advantage in monitoring loans.

References Economic Theories of the Firm: Past, Present and Future (1988) Limited Liability and the Development of the Business Corporation Ownership of the Firm