© 2009 pearson education canada 19/1 chapter 19 the theory of the firm

© 2009 Pearson Education Canada19/1

Chapter 19Chapter 19

The Theory of the FirmThe Theory of the Firm


Who Owns the Firm?Who Owns the Firm?

Ownership means essentially 3 things:Ownership means essentially 3 things:

1.1. Control of decisions within the firm.Control of decisions within the firm.

2.2. Residual claims on the firm.Residual claims on the firm.

3.3. The right to sell the rights to the above.The right to sell the rights to the above.


Control of Decisions Within the FirmControl of Decisions Within the Firm

Control includes deciding what Control includes deciding what products to make, how to produce products to make, how to produce them, how to sell them and what them, how to sell them and what prices to adopt.prices to adopt.


Residual Claims on the Firm.Residual Claims on the Firm.

A residual claimant has the right to A residual claimant has the right to take home income from profits take home income from profits (revenues less costs).(revenues less costs).

Within a firm there may be many Within a firm there may be many types of claimants (stock holders, types of claimants (stock holders, employees with bonuses, etc.).employees with bonuses, etc.).


The Right to Sell Ownership The Right to Sell Ownership and Residual Claims.and Residual Claims.

Ownership involves the right to Ownership involves the right to transfer the assets of the firm.transfer the assets of the firm.

Stockholders may have the right to Stockholders may have the right to hire and fire a CEO, but not the right hire and fire a CEO, but not the right to negotiate capital purchases. to negotiate capital purchases.


Figure 19.1 The pattern of ownershipFigure 19.1 The pattern of ownership


Three Relationships Between Residual Three Relationships Between Residual Claimants and Control of the FirmClaimants and Control of the Firm

1.1. Owner-operated Owner-operated -The person who -The person who makes the managerial decisions that makes the managerial decisions that affect the firm’s profits is the same as the affect the firm’s profits is the same as the person who lays claim to that profit.person who lays claim to that profit.

2.2. Partnership Partnership -The ownership and -The ownership and management functions are jointly shared management functions are jointly shared by two or more persons who work in the by two or more persons who work in the firm.firm.


Three Relationships Between Residual Three Relationships Between Residual Claimants and Control of the FirmClaimants and Control of the Firm

3.3. Corporation Corporation - where - where residual residual claimancyclaimancy is almost totally is almost totally separate from management or separate from management or control. For example in publicly held control. For example in publicly held corporations residual claimancy is corporations residual claimancy is spread over the share holders and spread over the share holders and at the same time executives at the same time executives exercise control within the firm. exercise control within the firm.


Organizational FormsOrganizational Forms

The central hypothesis of the modern The central hypothesis of the modern theory of the firm is that the theory of the firm is that the organizational forms that we organizational forms that we encounter every day are the ones encounter every day are the ones that achieve the closest possible that achieve the closest possible identity between the objectives of identity between the objectives of the individuals inside the firm and the individuals inside the firm and those of the firm as a whole. those of the firm as a whole.


The Owner-Operator FirmThe Owner-Operator Firm

For simplicity, it is assumed that each For simplicity, it is assumed that each unit of effort generates $1 of income. unit of effort generates $1 of income. ((yyRR=e=eRR).).

At the equilibrium of the one–person firm, At the equilibrium of the one–person firm, the slope of the indifference curve the slope of the indifference curve (MRS=the rate at which additional effort (MRS=the rate at which additional effort generates additional income) is equal to generates additional income) is equal to 1. (see Figure 19.2) 1. (see Figure 19.2)


Figure 19.2 Preferences over effort and Figure 19.2 Preferences over effort and incomeincome


Figure 19.3 The one-person firmFigure 19.3 The one-person firm


A Partnership AlternativeA Partnership Alternative

For the two person firm, the sum of their For the two person firm, the sum of their incomes must equal the effort they jointly incomes must equal the effort they jointly expend: yexpend: yRR+y+yVV=e=eRR+e+eVV..

One partner’s income is determined by the One partner’s income is determined by the following income effort relationship: following income effort relationship: yyRR=(e=(eRR+e+eVV)/)/2.2.

The partnership fails to create the optimal The partnership fails to create the optimal private incentive because neither partner private incentive because neither partner can capture the whole added output from can capture the whole added output from increasing his/her personal effort. increasing his/her personal effort.


Figure 19.4 Shirking in a partnershipFigure 19.4 Shirking in a partnership


Figure 19.5 The partnership equilibriumFigure 19.5 The partnership equilibrium


Pareto-Optimality and the Choice of Pareto-Optimality and the Choice of InstitutionsInstitutions

Modern theories of the firm suppose that Modern theories of the firm suppose that a Pareto-optimal organizational form will a Pareto-optimal organizational form will be chosen. be chosen.

An organizational form is Pareto-optimal An organizational form is Pareto-optimal if there is no other organizational form if there is no other organizational form that will leave all parties at least as well that will leave all parties at least as well off and at least one party better off. off and at least one party better off.


Team ProductionTeam Production

Team productionTeam production is an arrangement is an arrangement in which two or more workers in which two or more workers accomplish a productive task through accomplish a productive task through joint effort.joint effort.

When the When the productivity gainsproductivity gains associated with joint product (B) are associated with joint product (B) are large enough, the partnership is large enough, the partnership is preferred to one–person firm.preferred to one–person firm.


Figure 19.6 The owner-operated firmFigure 19.6 The owner-operated firm


Owner-Operated FirmOwner-Operated Firm

In absence of contracting or In absence of contracting or monitoring costs, the owner-operated monitoring costs, the owner-operated team is Pareto-preferred to both the team is Pareto-preferred to both the one-person firm and the partnership.one-person firm and the partnership.

This notion is illustrated by comparing This notion is illustrated by comparing equilibriums C and D in Figure 19.6.equilibriums C and D in Figure 19.6.


Contracting and Monitoring CostsContracting and Monitoring Costs

Our model will now be extended to Our model will now be extended to include costs of entering into contracts include costs of entering into contracts with employees and monitoring with employees and monitoring employee productivity.employee productivity.

Roberta must pay for half the monitoring Roberta must pay for half the monitoring costs (M) but can keep all income costs (M) but can keep all income generated from her effort.generated from her effort.

Her income-effort relationship is:Her income-effort relationship is:

yyRR=Be=BeRR-M/2-M/2


Figure 19.7 The owner-operated firm Figure 19.7 The owner-operated firm with monitoring costswith monitoring costs


Contracting and Monitoring CostsContracting and Monitoring Costs

Given the income–effort relationship, Given the income–effort relationship, Roberta can attain point V in Figure 19.7.Roberta can attain point V in Figure 19.7.

The following contract will allow Roberta The following contract will allow Roberta & Victor to attain point V:& Victor to attain point V:– Victor will receive income Y’ from Roberta if Victor will receive income Y’ from Roberta if

he supplies e’ or more units of effort.he supplies e’ or more units of effort.– However, if he supplies less than e’ units of However, if he supplies less than e’ units of

effort, he will receive no income.effort, he will receive no income.


Pareto-Optimal Organizational Forms:Pareto-Optimal Organizational Forms:

Depending upon the productivity Depending upon the productivity advantage associated with team-advantage associated with team-work (B) and the costs of monitoring work (B) and the costs of monitoring (M), any one of the three (M), any one of the three organizational forms considered can organizational forms considered can be Pareto-optimal relative to the be Pareto-optimal relative to the others.others.


Figure 19.8 Pareto-preferred organizational formsFigure 19.8 Pareto-preferred organizational forms


Specialization and the Specialization and the Division of LabourDivision of Labour

According to Adam Smith (1776), three factors According to Adam Smith (1776), three factors explain increased productivity from explain increased productivity from specializationspecialization and and division of labourdivision of labour::

1.1. Specialized workers are more productive via Specialized workers are more productive via repetition (learning by doing).repetition (learning by doing).

2.2. Workers save time by not switching tasks.Workers save time by not switching tasks.

3.3. Specialization encourages technical progress.Specialization encourages technical progress.


Transaction CostsTransaction Costs

A firm will expand to the point at A firm will expand to the point at which the cost (including transaction which the cost (including transaction cost) of adding another function in- cost) of adding another function in- house is just equal to the cost house is just equal to the cost (including transportation costs) of (including transportation costs) of coordinating that function through coordinating that function through the marketplace.the marketplace.


Generic Versus Specific InputsGeneric Versus Specific Inputs

On one hand, firms have the On one hand, firms have the incentive to buy incentive to buy generic inputsgeneric inputs, , because they can thereby avoid the because they can thereby avoid the difficulties associated with difficulties associated with harmonizing the interests of harmonizing the interests of individuals within the firm.individuals within the firm.



On the other hand, firms have a On the other hand, firms have a disincentive to buy disincentive to buy specific inputsspecific inputs from other firms because these from other firms because these inputs are subject to high transaction inputs are subject to high transaction costs across markets.costs across markets.



Whether we find decentralization Whether we find decentralization (coordination of economic activity via (coordination of economic activity via markets) or centralization (coordination of markets) or centralization (coordination of economic activity within firms) depends economic activity within firms) depends upon whether the advantages of upon whether the advantages of decentralization outweigh the resulting decentralization outweigh the resulting contracting costs.contracting costs.

© 2009 pearson education canada 19/1 chapter 19 the theory of the firm

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