Hart, O. (1989) An economist’s perspective on the theory of the firm, Flashcards
GOAL
a sense of how economists think about firms
Most formal economic models of the firm are
Most formal economic models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organizations we see in the world.
Established theories
1. Neoclassical:
most common theory
- Views the firm as a set of feasible production plans. A manager oversees this production, buying and selling inputs and outputs in a market to choose the plan that maximizes the owners welfare. Welfare is usually profit or, if undefined, value.
- PROS:
o Good for mathematical formalization
o Useful for analysing a firms production choices towards exogenous change
o Useful for analysing consequences of strategic interaction between firms during imperfect competition.
- CONS:
o Does not explain how production is organized, the conflicts of interest between its owners, managers, workers and consumers, or how the goal of profit-maximization is achieved.
o Begs the question of what defines a given firm or its boundaries. E.g. does not explain consequence of a merger or split.
o A rudimentary explanation of how firms function
Established theories
2. Principal-agent theory
recognizes conflicts of interest (agency)
- Acknowledges the conflicts of interest between different economic actors through observability problems and asymmetries of information. Still views the firm as a production set. However, assumes manager has other goals than the owner. Thus, profit-maximization for the owners is impossible through contract with a manager. Use of incentives may be used to try to reduce loss to agency but will never be optimal.
- PROS:
o Beginning of a managerial firm
- CONS:
o Fails to define a given firm or its boundaries. E.g. does not explain consequence of a merger or split
Established theories
3. Transaction cost economics: the cost of doing business
the cost of doing business
- Introduces the notion of thinking, planning, and contracting costs that accompany a transaction. In some situations, these costs will be lower if a transaction is carried out within a firm rather than in the market. Even within the firm, it brings costs of its own such as costs of errors or administrative rigidity.
- PROS:
o Defines the boundary of the firm: within a firm, transactions occur as a result of instructions or orders issued by a boss, and the price mechanism is suppressed.
- CONS:
o Questions the dichotomy in the role of authority within the firm and role consensual trade within the market: What happens if an employee does not obey instructions? it is not clear that an employer can tell an employee what to do, any more than a consumer can tell her grocer what to do. Being fired is the maximum penalization for both.
o > it is unclear why the problems must be solved through the firm and cannot be solved through the market
Established theories
4. The firm as a nexus of contracts
No difference between inside or outside the firm
- Both categories of transactions are part of a continuum of types of contractual relations, with different firms or organizations representing different points on this continuum.
- PROS:
o Helpful in showing contracts to be essential to the firm
o Shows the firm not to be an individual, a firms behaviour is the outcome of a complex equilibrium process
- CONS:
o Begs the questions why particular standard forms are chosen. And why standard forms are chosen
o The consequences of change, merger failure is not only cosmetic and brings major downfall. Thus, how does that work?
A Property rights approach to the firm
Take the position that the right to choose these missing aspects of usage resides with the owner of the asset. That is, ownership of an asset goes together with the possession of residual rights of control over that asset; the owner has the right to use the asset in any way not inconsistent with a prior contract, custom, or any law.
Hence, when contracts are incomplete, the boundaries of firms matter in that these boundaries determine who owns and controls which assets. Thus, after a merger, its consequences are clear.
nonintegration is always better than integration, it is optimal to do things through the market, for integration only increases the number of potential hold-ups without any compensating gains.
It is worth noting that the property rights approach can explain how the purchase of physical assets leads to control over human assets
Main takeaway for us:
The conclusion is quite Coasian in spirit, but the logic underlying it is very different. Coase reaches this conclusion by assuming that a boss can tell a worker what to do; in contrast, the property rights approach reaches it by showing that it is in a worker’s self-interest to behave in this way, since it puts him in a stronger bargaining position with his boss later on.
A Property rights and the established theories
The property rights approach has features in common with each of the approaches described previously.
- It is based on maximizing behavior (like the neoclassical approach);
- it emphasizes incentive issues (like the principal-agent approach);
- it emphasizes contracting costs (like the transaction cost approach);
- it treats the firm as a “standard form” contract (like the nexus of contracts approach);
- and, it relies on the idea that a firm’s owner has the right to alter membership of the firm: the owner has the right to decide who uses the firm’s assets and who doesn’t.
Its advantage over these other approaches, however, is its ability to explain both the costs and the benefits of integration; in particular, it shows how incentives change when one firm buys up another one.
