Econ 106I (Galles) – Lecture 1 (January 12th, 2005)
Econ 106I: Organization of the Firm
1st question referring to an article has its name in it
Read the questions before you read the articles.
5 weeks from today, there will be a midterm (40% of the grade)
Don’t participate in “academic bulimia”!
A firm is usually a “black box” represented by cost functions
Set marginal everything equal to marginal everything else
This is missing the presence of managers
With cost functions only, MP of managers=0. This would imply that the wage of managers should be zero.
Not observed
Hayek – Governments have a hard time central planning
A firm is an island of central planning
Can choose what to plan and what not to plan
Difficulties
Alchian 1, 2 – Difficulties with information and uncertainty and change
Don’t we tell firms just to maximize profits?
We assume away uncertainty complete.
What if you have a demand “cloud?” How would you maximize profits?
**Diagram**
As soon as you draw curves well-defined, you assume perfect knowledge
Most painful assumption
Search cost – Cost of acquiring demand/marginal cost curves is NOT zero.
What does this do to equilibria?
Why do firms exist? Coase
Looks at general equilibrium model and asks, “Do we see firms?”
Looks at the real world and asks, “Do we see firms?”
What types of firms come about when? (Section III)
Shirking
How do principals manage their agents?
Different incentives lead to inefficiency
How good an “agent” were you when your parents asked you to do something?
Monitoring, bonding, shirking exist with real people.
How do owners monitor managers?
How do managers monitor workers?
Team production
Vertical relations and integrations
Any time someone supplies someone else, there is a possibility of someone ripping the other person off
Explicit, implicit contracts, purchasing
Market for takeovers/takeover defense
“Poison pills,” “green mail,” “golden parachutes.”
Profit vs. non-profit firms
No residual claimant in non-profit firms
Is there a takeover market for non-profit firms? No
They just generate the pretense of monitoring
There is no demand for marketing when we assume demand curves
In the real world, there are marketing costs
In an “organized exchange,” our models work
There are no barriers to entry in the competitive model
Information is a barrier to entry in the real world
People don’t know that you are as good as someone else – reputation
Managers maximize profit while the “coin is still in the air.”
Everyone freeloads off the one who has the most to lose in a group project situation
Restrict entry to other “A” students – this still has problems.
We have to look behind the cost curves
Transactions costs are usually assumed to be zero.
Enforcement costs as well
Hayek – Costs of central planning and how markets do things better
Does not address costs of markets
Heterogeneous input models
We usually assume every unit of L is the same
Monitoring costs
Interviewing process – organized system of lying
Cobb-Douglas production function automatically assumes you can figure out each person’s marginal product
Once you sneak in a wrong assumption, you get misleading results
Contents of articles:
Hayek – difficulties of central planning/methodological issues
Our models assume you know what you can’t know
Firms centrally plan some things – can choose what to plan
Criticizes mathematical economics
Even if logic is correct, if you sneak in assumptions, you get wrong results
Alchian 1 – Uncertainty and implications for profit maximization
Alchian 2 – Problems of costly information and search costs
We usually assume away geography
Price stability can be important goal here
Implicit assumption: organized markets
Search costs allow price discrimination in competitive markets
Coase – Why firms?
Is management free? Are transaction costs zero?
Management costs versus transaction costs.
Alchian 3 – Team production – What advantages are there?
Introduce shirking problem
Internal markets (hiring within versus interviewing)
Interviewing versus dating
“Lower divorce rates if you meet in college. You know the real them. Do they cheat/ What do they really look like without makeup? Information costs are lower here.”
Alchian 4 – Property rights/ownership
Capitalization – different “long runs”
Which fixed factor is the relevant one?
Firms do not maximize short-run profits – reputation effects
On an organized exchange, short-run profit makes sense
For profit versus non-profit
Separation of ownership and control
Jensen – Agency relationships – delegation
Agency costs – residual loss
Aligning incentives
Bonding costs
Finance questions – stocks versus bonds, etc. – structure
Fama – Managements and the board of directors
Tournament theory
Vertical relationships
Klein 1 – Vertical integration, explicit/implicit contracting
Telser – Marketing relations
Klein 2 – Franchising questions
Monitoring enforcement questions
Demsetz – Key to understanding is not holding capital fixed
Information is the short-run fixed factor
Specialization versus self-sufficiency
Conservation of information costs
Hayek article – Famous for when it happened – end of WWII
Computers will allow for efficient social planning
Evidence supported socialism
One of ten people who disagreed with social planning
You will throw away information if you centrally plan
It is logically impossible for a central planner to have that information
The problem is not solved since the assumptions are what brought about the solution. Assume the problem away.
Traffic school – Who came up with them? Definitely not insurance companies. Probability of accident goes up with number of speeding tickets. Traffic school eliminates valuable information.
A municipal judge came up with this
Let’s not punish them. Let’s teach them.
Unisex insurance throws away valuable information
Information helps predict risk
Information is the largest creator of wealth
Trade is not inherently productive – ownership by those who value the item more creates wealth
Transportation is not either – moves to higher-valued location is what creates wealth
Speculation – moves to higher-valued time
Production – rearrange atoms to higher-valued form.
All important wealth creation requires informational details.
Throwing away details automatically eliminates efficiency.
Hayek on firms
Information decides whether or not to vertically integrate or let others make decisions.
Consider an assembly line
**Diagram**
Assembly line – potentially, the workers on an assembly line have valuable information. How valuable are these details versus how costly is this information to generate and to use?
Rearranged form of assembly line to see who was shirking – increased productivity by 45%.
Problem of information holds in firms as well.
Why don’t firms have suggestion boxes anymore?
Everyone submits suggestions that are aimed at maximizing suggestor’s utility, not company profits
Benefits of suggestions are low
Carnegie provided incentives for suggestions. If you could save him one fifth of one cent per pound of steel, he would give you one years’ salary.
Spreadsheets – raise or lower cost to firm?
What do spreadsheets lower cost of?
Calculating and organizing
But now, there is a lot more stuff to go through.
Boss screen – Playing games on computers on company time.
Did computers really raise efficiency?
Central server – less efficient but lowers monitoring costs
Height of cubicle – optimal for worker: high enough to see boss coming.
Why are offices carpeted? So you can’t hear the boss coming.
Read Hayek. Read through page 50 in Alchian.