Econ 106I (Galles) – Lecture 4 (February 2^nd, 2005)

Alchian ch. 2:

(p. 44) Why might you want to stabilize prices? To reduce search costs

Are there search costs in the competitive model? No

Are there search costs in the monopoly model? No

Economists force everything into competitive or monopoly model, but neither one has search costs. They have both assumed them away.

When prices are flexible, people are more likely to make costly mistakes.

They will invest resources in avoiding these mistakes (bear search costs) and would be willing to pay to save on them.

If I can charge you $2 more, but it saves you $10 in search costs, are you better off? Yes

Why might antitrust lawyers consider this to be bad?

They are looking only at prices and not quantities.

Efficiency argument for MSRP – saves on search costs

Once I stabilize prices, I need to ensure I have enough quantity to satisfy demand

Lines

Excess capacity

Excess inventory

All of these are substitutes for each other

Barnes and Nobel is experimenting with priting up books

Excess capacity versus excess inventory

For customized products, excess inventories are not lowest cost way of stabilizing prices

Excess capacity is.

For standardized products, excess inventories are cheapest (e.g. steel versus cement)

Cement producers use lots of electricity

They use grinders during off-peak periods

Restaurants put up with waiting sometimes.

Other times, they put up with empty seats

What is the lowest cost way of reducing search costs?

(p. 47, 1^st paragraph) Long sentence. Connect each clause to the end.

Smaller, more frequent fluctuations in demand will lead to more stabilized prices

Greater search costs will lead to more price stability as it will increase the benefit of price stability

Greater value of buyer’s time will lead to more price stability

Less burdensome waiting will lead to more price stability as it will lower the cost of price stability

Why does it take longer to sell a custom house than a standard house? More search costs involved

High end/low end products – more search costs than the middle of the road products

Lower cost of holding inventories will lead to larger inventories to stabilize prices.

Will shorten queues since queues are a substitute for inventories

(pp 48-49) Cost of producing at the last second versus cost of producing beforehand

Competitive result with shortages some of the time

Consistent with real world competition (with search costs)

(p. 50) Just because shortages are efficient sometimes does not mean they always are. Two reasons for shortages other than to reduce search costs:

i) Value of item is too low to enforce property rights

Parking lots, freeway space, etc.

Drives costs to zero – permanent shortages

Berkeley and parking meters example

Costly enforcement of property rights

ii) Nonprofit organizations do not get to keep profits, so they permanently underprice goods to reduce costs of having people complain.

There are important margins at which they do not capture benefits. This will lead to a permanent shortage

Rose Bowl foundation (non-profit organization) – does not capture benefits of higher prices

Administration allowed them to capture profits.

These are not efficient, however. Alchian’s theory does not apply to these.

Coase: The Nature of the Firm

Famous for asking, “Why do we have firms?”

Firms in general equilibrium model? No

Firms in the real world? Yes

What is missing in the model?

Tradeoffs between transaction costs and management costs.

**Diagram**

As soon as you recognize the fact that transaction costs are nonzero, the need for firms arises.

(p. 2) Recognize what is included in transaction costs

How do we lower transaction costs?

Central contracting lowers contracting costs. Firms provide this.

What if we want long-term contracts?

Reduces transaction costs of short-term contracts.

Firms are defined more by labor contracts

Unions take advantage of the details that are left out of the contract

Tradeoff between flexibility and hold-up issues

(p. 6) As firm gets bigger, cost of management rises.

At some point, cost of management exceeds cost of using market.

a) Firm will be larger when management costs are lower or when costs rise more slowly

**Diagram**

b) The larger the firm, the more mistakes you will make.

a) and b) became the “transaction cost” theory of the firm

If management costs decrease, everything else constant, firms become larger

If transaction costs decrease, everything else constant, firms become smaller

Coase makes mistakes: Telephone and telegraphs lower management costs, which would imply larger firms

But this could also decrease transaction costs, which would imply smaller firms.

The results are ambiguous. Technological innovations lower both types of costs.

c) This is ignored in the literature except for Alchian/Demsetz.

Economies of scale in input markets, which could offset the increase in management costs

The beginning of the factory situation:

Central sources of power led everyone to move closer to each other, which lowered transaction costs. This should have made firms smaller

But this also cause management costs to decrease by developing “team production”. Thus, firms got larger

Alchian and Demsetz

Superior internal labor, capital, idea market

(pp 105-107), (p 109), (pp 241-243)

To explain the structure of the organization

Corporations, sole proprietorships, non-profit organizations

(p. 74) Disagrees with Coase

What power do employers have over workers?

The worker can quit if pushed to do so.

The core question lay in a team use of inputs.

The metering problem – there are two substitutible ways to meter

How well do markets solve metering problems for farms?

Very well for the individual famrers

Does the market solve the problem of metering in a team productin setting where marginal product of an individual cannot be measured? No, it doesn’t

Furniture movers – when teamwork is necessary.

Economies of teamwork:

Marginal product of A+B – shirking costs > Marginal product of A + Marginal Product of B

When working together, there may be shirking since each worker has incentive to work less hard

Once you have shirking costs, this becomes a metering problem. There are two ways of dealing with it:

Live with it

Take action to reduce it

Team projects in school teach you to be a better shirker

If I can only measure your outputs, does it matter what your inputs are?

The determinants of firm types are economies of teamwork and effectiveness of metering

Proprietorships arise when:

Economies of team production are tiny

Specialist monitoring is very poor

Why do artists work alone? Very low economies of team production. Very difficult to monitor.

Corporations arise when:

Economies of team production are enormous and

Specialist monitoring works well to reduce shirking

Assembly lines came about to reduce monitoring costs by effectively assigning tasks

Parnerships (Law and Accounting especially) arise when:

Economies of team production are moderate and

Specialist monitoring does not work well

By making you a partner, you monitor yourself

When you are a young lawyer, they give you standard tasks to measure your competence

After you prove you are competent, you must prove that you can mointor others

Then they might allow you to become a partner

What if corporations are illegal? Pick partnership. But this will have its own problems.

A similar result will emerge when corporations have high taxes

What is the problem with non-profits? No monitoring leads to shirking

(pp 76-77) If I have a Cobb-Douglas production function, I am assuming that I can identify the individual marginal productivities

You cannot monitor these in many situations

You cannot identify the source of problems.

Metering problems are not addressed in the standard model

Marginal productivity does not create rewards. It is the rewards that determine the marginal productivity

If the economic organization meters poorly, productivity will be lower.

The government does not reward well for productivity

Working for the government is a signal that you are a slacker

What if you are in a n industry in which you do not have much power?

Proxy for slacker

Why was there a problem when they deregulated the savings and loan industry?

The bad MBA’s self-selected this industry because it formerly was regulated and they didn’t have much power

Not good managers when they have power, however.

Marx had never been in a factory. He assumed that if people are watching your input, it must be the input that cuases the item to have value. But output cannot be measured, so this is just a proxy.

Exams versus attendance (measuring output versus input)

(p. 79) Tradeoff between living with shirking and fixing it

If metering costs were zero, there would be no incentive to shirk.

Consider a five menber team: No member bears 100% of the costs

**Diagram**

Who pays the welfare costs in a team? The team does

What happens if we can better align incentives to decrease shirking? Everyone could be better off

This is an example of a self-finance subsidy

(p. 82) Other members want to get rid of biggest shirker. Why can we not count on outside competition to take care of this?

It is hard to identify the shirker.

Working Girl –demonstrates her skills. Good signal, so she gets a good job

Chinese boat pullers and whip guy story

Alchian – our view of the firm is not inconsistent with Coase

(p. 87) Team production and metering are important in Alchian/Demsetz but not Coase

(p. 88) Team use of central power source became grater.

(pp. 88-89) Knight – The less risk averse you are, the more likely you are to become the owner.

(p. 91) Applications – profit-sharing firms: Less reward to the monitor

Monitor does a worse job, which tends to lead to smaller firms

Read chapters 3 and 4 in Alchian