The Organization of the Firm

							Production Function

  Production Function – a function that
   defines the maximum amount of output
   that can be produced with a given set of
   inputs.
  Q = f(K,L)
        Where K = Capital and L = Labor
Various Production Functions

    Linear Production Function
      Q = aK + bL
      Inputs are perfect substitutes
      Marginal Product of Labor = b

    Leontief Production Function
      Q = min(bk, cL)
      Also called the fixed proportions production
       function
      Inputs are perfect complements
Cobb-Douglas Production
Function
  Q = KaLb
  Capital and Labor are both substitutes
   and complements for each other.
  Productivity of each input depends upon
   the amount of the other input employed
  Marginal Product of Labor = bKaLb-1
      On the Hiring of Workers
• Why do firms hire workers? Return to Cost-
  Benefit Analysis
• Cost = The wage the worker is paid. This is
  generally set in the market, not by the firm.
• Benefit = The productivity of the worker
  (marginal product) * the value of this
  productivity in the market place (price)
              VMP vs. MRP
• Value Marginal Product = Marginal Product of
  Labor * Price of Output
   – Relevant when the firm has no control over
     market price.
• Marginal Revenue Product = Marginal
  Product of Labor * Marginal Revenue of
  Output
   – Relevant when the firm has some control
     over market price.
      Profit Maximizing Hiring

• If W > MRP      What action should the firm
  take?
• If W < MRP      What action should the firm
  take?
• The firm will maximize profits with respect to
  the hiring of workers when W = MRP
       The Importance of Stage Two

• In what stage of production, then, do firms
  operate? Only in stage two.
• In stage one, increases in the labor force will
  increase the MRP. If it made sense to hire
  the previous workers, and the next worker
  offers a higher MRP, then it makes sense to
  hire the next. Hence firms will not stop
  hiring workers in Stage Two.
                     The Long-Run
• How does a firm decide to expand production? Profit
  maximizing output > average cost minimizing output.
• Expanding productive facilities moves the firm from the
  short-run to the long-run.
• Long run - the shortest period of time required to alter the amounts
  of all inputs used in a production process.
   – A period of time long enough for all inputs to be varied.
            Economies of Scale

• Economies of scale - reductions in the minimum
  average cost that come about through increasing
  plant size.
   – specialization of labor.
   – more efficient yet larger equipment.
   – greater volume of output increase efficiency
     from learning.
• Constant returns to scale - increases in plant size do
  not affect minimum average cost.
        Diseconomies of Scale
• Diseconomies of scale - increases in plant size
  increase minimum average cost.
  – supervision of workers more difficult (morale
    declines).
  – lengthening of the managerial chain leads to
    disorganization.
• Long run average total cost is a summary of
  our best short-run cost possibilities.
Economies of Scope

    Economies of Scope – when the total
     cost of producing two types of
     outputs together is less than the cost
     of producing each type of output
     separately
Economic Efficiency
  Technical efficiency - as few inputs as
   possible are used to produce a given
   output.
  Economic efficiency - the method that
   produces a given level of output at the
   lowest possible cost.
  Economic efficiency is achieved when the
   amount of productivity received from each
   input per dollar spent is equal.
Cost Minimization in the Long-Run


   The production of many goods does not
    follow a fixed recipe. How does the firm
    choose the inputs to use in production?
   MP1/P1 = MP2/P2 = ....... = MPn/Pn
   WHY IS THIS IMPORTANT? TO MAXIMIZE
    PROFITS YOU MUST COST MINIMIZE.
   HOWEVER, COST MINIMIZATION DOES
    NOT NECESSARILY MEAN PROFIT
    MAXIMIZATION.
 The Organization of the Firm
 The Multi-Plant Problem
 Cost-Volume-Profit Analysis (in book)
 Managerial Decisions
  – Securing Inputs and Transaction Costs
  – Managerial Compensation
  – Worker-Management Relations
         Long-Run Average Cost
 Capacity – Output level at which short-run
    average costs are minimized.
   If a firm moves beyond ‘capacity’ the firm may
    want to consider building a larger plant.
   BE ABLE TO ILLUSTRATE THIS STORY IN THE
    SHORT-RUN
   Minimum Efficient Scale – Output level at which
    long-run average costs are minimized.
   BE ABLE TO ILLUSTRATE LONG-RUN AVERAGE
    COST AND IDENTIFY THE LEVEL OF OUTPUT
    CORRESPONDING TO MES.
Firm Size and Plant Size

 Multi-plant Economies of Scale – Cost
  advantages from operating multiple
  facilities in the same line of business
  or industry.
 Multi-plant Diseconomies of Scale –
  Cost disadvantages from operating
  multiple facilities in the same line of
  business or industry.
    The Economics of Multi-Plant Operations

 Elements needed for problem
    Equation for Demand Curve
    Short-run Total Cost Function

 Steps in Solving the Problem
    Solve for profit maximizing output, price, and profit.
    Solve for average cost minimizing output.
    Solve for MC when firm produces at capacity.
    Set MR equal to MC at capacity to determine optimal
     multi-plant operation.
    Determine the optimal number of plants.
    Determine price and profit when firm employs the
     optimal number of plants.
    Methods of Acquiring Inputs:
          Spot Exchange
 Spot Exchange – an informal
  relationship between a buyer and seller
  in which neither party is obligated to
  adhere to specific terms for exchange.
 This is often used when inputs are
  standardized so effort in finding the
  ‘best’ input is not needed.
    Methods of Acquiring Inputs:
    Acquiring Inputs Via Contract
 Contract – a formal relationship
  between a buyer and seller that
  obligates the buyer and seller to
  exchange at terms specified in a legal
  document.
 Contracts can reduce uncertainty, but
  increase the transaction costs incurred
  by the firm.
    Methods of Acquiring Inputs:
        Internal Production
 Vertical Integration – a situation where
  a firm produces the inputs required to
  make its final product.
 Vertical integration (alternative
  definition)- various stages of
  production of a single product are
  conducted by a single firm.
 Motivation: Reduces Transaction
  Costs
         Transaction Costs
 Transaction costs - the expenses of
  trading with others above and beyond
  the price. i.e. the cost of writing and
  enforcing contracts.
 Transaction costs determine whether
  markets are internalized or allowed to
  remain external to the firm.
 More on Transaction Costs: The Work of
           Oliver Williamson
    Basic concepts that underlie
     transaction costs analysis.
1.    Markets and firms are alternative means for completing related sets
      of transactions.
2.    The relative cost of using markets or a firm’s own resources should
      determine the choice.
3.    The transaction cost of writing and executing contracts across a
      market is a function of
     1.   the characteristics of the involved human actors
     2.    the objective properties of the market
4.    In sum, both human and environmental factors impact the
      transaction costs across firms and markets.
       More from Williamson
 Purpose of this analysis is to identify
  the set of environmental and human
  factors that explain both internal firm
  and industrial organization.
 Key environmental factors:
  Uncertainty and number of firms
 Key human factors:
  Bounded rationality and opportunism
           Bounded Rationality and
               Opportunism
   Bounded rationality - the limited human capacity to
    anticipate and solve complex problems.
   Opportunistic behavior - Taking advantage of another
    when allowed by circumstances.
   High transaction costs:
      Specialized products: The creation of specialized
       products, where only a single buyer and/or seller exists,
       can lead to opportunistic behavior. This provides an
       incentive for vertical integration.
      Changing market conditions: Bounded rationality and
       uncertain market conditions make the writing and
       enforcement of contracts involving future conditions
       undesirable for both parties. Such high transaction costs
       increases the likelihood of vertical integration.
Market vs. Internal Production
   Labor theory: Wages = Marginal Revenue
    Product
   Marginal Revenue Product = Marginal
    Revenue of Output (MR) * Marginal Product of
    Labor (MP)
   However, for this to be true for each worker a
    firm would need to measure MP.
   What if a firm cannot measure MP? Then a
    worker can reduce effort an still maintain the
    same wage.
   When monitoring costs are high, a firm has an
    incentive to sub-contract work.
   Why? For independent workers the wage
    (profit) is closer linked to productivity.
    More Benefits from Vertical Integration

 In addition to transaction costs, vertical
  integration is also motivated by two
  additional considerations.
 Vertical integration provides assurance
  of supplying inputs/outputs in a market
  that may be unstable.
 Threatens potential entrants by raising
  entry barriers (aluminum example)
    The Principal-Agent Problem
   A principal is the person who wants an action taken.
    In the work environment, this is the owner of the firm.
   The agent is the person who takes the action. In the
    work environment, this is the worker.
   If motivations differ between the principal and agent,
    and information is not perfect, a principal-agent
    problem exists.
   A specific example is the issue of moral hazard. Moral
    hazard occurs when the agent can take actions that the
    principal cannot directly observe that will reduce the
    welfare of the principal. For example, consider
    shirking.
   How can the firm limit shirking?
       Difficulty of Vertical Integration
             Shirking of Workers
   Shirking - the behavior of a worker who is putting
    forth less than the agreed to effort.
   Efficiency Wages – Paying the worker a wage above the
    market wage.
   Why is this necessary? Because workers can vary
    productivity, a firm may need to pay higher wages to
    ensure higher levels of output.
   Why would firms pay efficiency wages? In other words,
    why do higher wages elicit higher productivity.
         a.      The Gift exchange hypothesis
         b.      Worker turnover
         c.      Worker quality
               Shirking Defense
   How do firms prevent the manager from shirking?
    Make the manager a residual claimant.
    • Residual claimant - persons who share in the profits of the
      firm.
   How do firms prevent workers from shirking?
    • Profit sharing – mechanism used to enhance workers’ efforts
      that involve tying compensation to the underlying profitability
      of the firm
           STOCK OPTIONS, etc..
    • Revenue sharing – mechanism used to enhance workers’
      efforts that involve tying compensation to the underlying
      revenues of the firm
           SALES COMMISSIONS, TIPS, etc...
           NO INCENTIVE TO LOWER COSTS
        Teams and Productivity
   Teamwork is employed when a team of individuals can
    produce more than the sum of individuals working
    alone.
   Observing individual productivity is difficult, so
    shirking can occur: The Free Rider Problem
   Profit Sharing: If team members share in the profits of
    the firm, then they have an incentive to monitor other
    team members. If the incentive to monitor exceeds the
    free-rider effect, profit sharing can increase
    productivity.
     More Defense: Piece Rates
   Piece-Rate Compensation – Employee is
    paid according to productivity.
   Such a compensation plan will increase
    productivity.
   Will only work if productivity can be
    measured.
   Problems
     • Teamwork will diminish.
     • Quantity is easy to measure, quality is
       not. Thus quality can suffer with this
       compensation plan.
       Subjective Evaluations
   Why are subjective evaluations
    employed? To encourage innovation,
    dependability, cooperation, etc...
   Subjective evaluations can lead to rent-
    seeking by workers, or actions taken to
    re-distribute resources from others.
   Subjective evaluations can also be quite
    inaccurate. Inaccurate evaluations can
    distort incentives.
      The Role of Management
   What is the primary role of the manager?
   To prevent shirking, which limits the
    production of the firm.
   In essence, employees employ the manager
    to raise the return to the firm.
   Implications: If the manager is poor,
    employees will leave. If the returns of the
    firm do not accrue to the employees, the
    employees will leave.
   Remember, the labor market is like any
    other market. Exchange takes place by both
    parties because benefits exceed the costs.
The Objectives of Management


   Managers seek to maximize utility (A.A. Berle and Gardner
    Means)
   Focus of these authors is on the separation of ownership
    and management, which arose due to the rise of the
    corporation.
   How would this impact market behavior? Studies have
    shown that managerial control is less profitable than owner
    control. Manager’s are more risk adverse, due to an
    inability to diversify.
   A related view.... Managers seek to satisfice (Richard Cyret,
    James March and Herbert Simon)
   In this class we assume that firms seek to maximize profits.
    This is a simplification.
   WHY DO WE NEED TO ANSWER THIS QUESTION? We need
    to know the motivation of the people we study.
Why Profits?
    Why do firms make a profit?
    The story from classical economics
    Payment to the capitalist-entrepreneur (i.e. profit) is comprised of
     three elements (according to classical economics)
       payment for the use of capital

       payment to the entrepreneur for managerial expertise

       payment as compensation for risk

    What is profit in the long-run?
    How can profits persist?