1 Theory of the firm

Question 1

What are downsides/critiques of the Rent‐Seeking Approach (Williamson)?

Answer 1

A weakness of the rent seeking approach is that it cannot explain why we observe hold‐ups between firms that do not result in integration. This approach does not consider any downsides of integration.

Question 2

Why are contracts in practice often incomplete?

Answer 2

Reasons for incomplete contracts:

1. Bounded rationality of contracting parties (hard to think of all future states)
2. Bargaining costs for writing contracts would be too high (agreeing on infinitely large future states)
3. Enforcement costs of complete contracts would be too high (checking that infinite conditions are fulfilled)

Question 3

What are pros/cons to contract clauses that 1) prevent a leaving partner from starting their own firm 2) oblige leaving partners to buy out?

Answer 3

Pro:

• leaving less attractive
• firm only loses partner

Con:

• harder to dissolve partnernship (i.e. when underperforming)
• implementation (what is a competing firm?)

Question 4

What is an incomplete contract?

Answer 4

A contract is incomplete if not all details relevant for the transaction are written down in the contract. The contract does not specify how the contraction parties should behave in all future states of the world.

Question 5

Give examples of transaction costs for the employer, that can arise when an employment contract is set up. Focus on Search and Information Costs!

Answer 5

Place job advertisement, screen applications, conduct interviews

Question 6

What is a hold-up problem?

Answer 6

Person A makes an investment at one time but can realize the returns only by transacting with person B later. To the extent that person B can extract some of the returns, person A does not have the incentive to invest optimally in the first place. This is called the “hold‐up” problem because person B extracts a share of the returns under the threat of holding up production.

Question 7

Give examples of transaction costs for the employer, that can arise when an employment contract is set up. Focus on Bargaining Costs!

Answer 7

Negotiate and write up contract of employment

Question 8

What types of transaction costs can arise when setting up an employment contract?

Answer 8

1. Search and information costs
2. Bargaining costs
3. Enforcement costs
4. Adjustment costs

Question 9

What is an example for an incomplete contract?

Answer 9

employment contracts do (almost) never specify all the specific tasks an employee has to perform over the course of his employment (e.g. contracts of scientific assistant read that HiWis provide assistance in research and teaching)

Question 10

What is the idea behind the Property‐rights approach?

Answer 10

Basic idea: allocating resources affects incentives (Grossman and Hart 1986)

• Here: resources = assets necessary for production (e.g., factory)

Question 11

What are property rights?

Answer 11

1. Rights of access: rights to take certain actions
2. Rights of exclusion: prevent others from taking certain actions
3. Profit (or cash flow) rights: rights to take the profit generated by the use of the asset

Question 12

What are transaction costs?

Answer 12

• Economic frictions that occur in practice
• ≠ producton costs!
• External TC -> in markets
• Internal TC -> in firms

Question 13

What are pros/cons to not having specialized partners in a firm?

Answer 13

Pro:

• threat to leave is less credible (clients won’t follow)
• easier to fill gap of leaving partner

Con:

• benefits from specialization cannot be realized

Question 14

How could a firm with several specialized partners prevent one partner from threatening to leave with the clients?

Answer 14

A) implement contract clauses that 1) prevent a leaving partner from starting their own firm 2) oblige leaving partners to buy out B) do not have specialized partners

Question 15

What are solutions to the hold-up problem?

Answer 15

1) Vertical integration: Beverage manufacturer buys the bottling company. Then, the decision and the investment stays in the firm. *Problem: incentive of the bottling company change once it is no longer an independent firm that sells a product for product 2) Beverage manufacturer contributes to the redesign of the plant with the Payment of at least 7 monetary units (only works if the redesign is verifiable)

Question 16

Why are contracts incomplete?

Answer 16

• Related to the existence of TC
• Bounded rationality -> not all contingencies are foreseeable, and even if so, including all of them would be extremely costly (e.g., bargaining costs)
• Observability vs. verifiability -> certain terms of a contract might be prohibitively costly to enforce

Question 17

Why can transaction costs appear?

Answer 17

TC can occur because of

• Bounded rationality (e.g., adjustment costs)
• Opportunistic behavior (e.g., enforcement costs)

Question 18

What are quasi-rents?

Answer 18

Value of an investment within the given relationship net of its value in its next best alternative use.

Question 19

What affects transaction costs?

Answer 19

TC are affected by

• Frequency of the transaction (e.g., search, information and bargaining)
• Degree of uncertainty (e.g., bargaining, enforcement, adjustment)
• Amount of transaction‐specific investments

Question 20

What is the difference between the terms observability and verifiability?

Answer 20

A task is observable but not verifiable if it can be observed by the contracting parties but not by independent third parties (e.g. a court). Observable but non-verifiable dimensions of a job cannot form part of a lawsuit since impartial third parties cannot observe these tasks. Therefore, it is hard to contract over observable but non-verifiable dimension of jobs. Example: the enthusiasm in the performance of a musician, how heartfelt the performance was

Question 21

Give examples of transaction costs for the employer, that can arise when an employment contract is set up. Focus on Enforcement Costs!

Answer 21

Controlling: measure job performance ( does the employee perform the task?); admonish in case of misconduct

Question 22

Give examples of transaction costs for the employer, that can arise when an employment contract is set up. Focus on Adjustment Costs!

Answer 22

Negotiate and write up contract amendments, e.g. adaptation of working hours, tasks, salary; credibly inform employee that these changes are necessary

Question 23

Which three scenarios do you have to calculate when considering a hold-up model?

Answer 23

1. Benchmark - First Best Solution
2. Nonintegration
3. Integration

Question 24

In a hold-up problem analysis, how would you calculate/analyze the first-best solution?

Answer 24

1. Set up the maximization problem for the overall surplus:
   [value of the produced good to D] - [costs/costly actions of producing the good for U]
2. Take partial derivatives to solve
3. Calculate the surplus Sᶠᴮ by plugging in variables

Question 25

In a hold-up problem analysis, how would you calculate/analyze the nonintegration solution?

Answer 25

1. Use backwards induction and start with the bargaining stage:
   
   • assume e.g. equal bargaining power and split the rent
   • calculate the resulting value of the good to D
2. Set up the maximization problem
3. Take partial derivatives and solve
4. Calculate surplus Sᴺᴵ by plugging in variables
5. Compare to other surpluses

Question 26

In a hold-up problem analysis, how would you calculate/analyze the integration solution?

Answer 26

1. There are no incentives for U to take any costly actions ( as s/he will get a fixed wage/transfer), so costly actions will be 0
2. calculate Surplus Sᴵ
3. Compare to other surpluses

Question 27

What else do you need to do once you have calculated the three model solutions for first best, nonintegration and integration in a hold-up problem?

Answer 27

• Compare the different surpluses.
• When will the firms integrate? (i.e. solve for the values of not yet known variables to see)

Question 28

Give examples of transaction costs for the employee, that can arise when an employment contract is set up. Focus on Search and Information Costs!

Answer 28

Read job advertisement, gather information about employer, write applications, job interviews

Question 29

Give examples of transaction costs for the employee, that can arise when an employment contract is set up. Focus on Bargaining Costs!

Answer 29

Negotiate and check terms of the contract

Question 30

Give examples of transaction costs for the employee, that can arise when an employment contract is set up. Focus on Enforcement Costs!

Answer 30

Controlling: verify correct payment; sue for parts of employment contract, insist on additional compensation agreed upon only verbally

Question 31

Give examples of transaction costs for the employee, that can arise when an employment contract is set up. Focus on Adjustment Costs!

Answer 31

Negotiate contract amendments, e.g. part time due to family commitments (parenting, elderly care); demand for pay rise, renegotiation due to offer of a better job

Question 32

In a hold-up problem, interpret the variables:

Q = q + a + ε

R = r + kc + η

c(a) = - αa²

c(c) = - γc

Answer 32

q, r = respective fixed value of product to D

a, c = costly effort for U to increase value of product to D

k = efficiency of effort when U improves by c

ε, η = random variation in value of product to D, not influenced by U

Question 33

Which three main theories of the firm are there?

Answer 33

1. Transaction cost approach
2. Rent seeking approach
3. Property rights approach

Question 34

How does the transaction cost approach explain the existence of firms?

Answer 34

Transaction should be brought inside the firm if

internal TC < external TC

Question 35

How does the rent-seeking approach explain the existence of firms?

Answer 35

• Contractual incompleteness can lead to appropriable quasi‐rents (e.g., from relationship‐specific investments) -> inefficient haggling for rents, hold‐up problems
• Integration can stop haggling for rents because it allows to resolve dispute by authoritative order

Question 36

How does the property-rights approach to firms explain interactions between suppliers?

Answer 36

• A party’s possibility to hold somebody else up creates incentives.
• The incentives can be both constructive and destructive.
• Integration can stop hold up and destructive incentives, but comes at the cost of also reducing constructive incentives.