Principles of Economics Unit 6 - 10

Question 1

Firm : an organisation which

Answer 1

• pays wages (w) to employ people (L)
• purchases inputs (K,M,Hc)
• to produce and market goods and services (Q) with the intention to make a profit

Question 2

Firm governance: Contracts Definition and What types

Answer 2

Contracts : A legal document that specifies a set of actions that parties must undertake

• Contracts for products sold in markets permanently transfer ownership for the good from the seller to the buyer
• Contracts for labour temporarily transfer authority over a person’s activities from the employee to the manager or owner

Contracts unite the people making up the firm -owners, managers, and empolyees - in their common interest in the firm’s success

Question 3

Firm governance: Dividing the profit and what revenues are used for

Answer 3

Revenues are the proceeds from selling the products. They are used to pay

• empolyees and managers: wages (w)
• suppliers: material input prices (Pm)
• Creditors : capital costs (interest rates, r)
• Government: taxes (T)

Profit π = TR − TC

Question 4

The residual claimant ?

Answer 4

The person/agents who receives the income left over from a firm or other project after the payment of all contractual costs.

Note: If TR ↑ π ↑ but w, pm,r, τ do not. → Firm is a stage

Question 5

The firm as a stage: Owners vs managers
Principle-agent Problem and How can Conflicting Interests Be Solved?

Answer 5

Owners have the ownership but managers have the control over the firm: conflicting interests

How to solve the conflicting interests?

1. Managerial compensation tied to firm performance
   (performance-related clause)
2. BoD (representing the owners) can fire a manager

Question 6

The Firm as a Stage: Managers vs. Workers
Why are contracts incomplete?

Answer 6

Contracts are typically incomplete

1. The manager does not know precisely how the employee will contribute
2. worker effort is unobservable

Incomplete contract: a contract that cannot enforce everything the firm and the worker care about (e.g. effort, attitude, working hours, emergencies)

Question 7

What happens to the economy when unemployment rises and unemployment benefits rise? and how does this affect the equilibrium

Answer 7

Higher unemployment benefits raise the reservation wage.

Higher unemployment raises the effort per hour.

For a given wage, different effort levels across scenarios.

Question 8

Summary for unit 6

Answer 8

1. The firm: a stage on which owners, managers and employees interact
2. Employment contracts are incomplete: they cover hours and working conditions: not the effort by the empolyees.
3. A class of models to understand the consequences of incomplete contracts : principle -agent models
4. Employers set wages > workers’ reservation wages
5. Workers receive an employment rent, which motivates them to work hard.
6. Public policies and the state of the economy affect worker incentives to provide effort.

Question 9

Imagine a shareholder company (a joint stock company). Is it effective for shareholders to monitor the performance of the management in a firm owned by many shareholders? Discuss implications for the incentives managers have. Introduce the collective action problem.

Answer 9

• There isn’t a perfect monitory device for the manager. As a manger is valued by what they do for the company.
  It is expensive for shareholders to monitor the effort of senior managers
  Managerial efforts drive effort drives profits
  Both sides of the contractual relationship care about. This is the heart of the principle agency problem Incomplete contracts.
  Collective action problem: A collective action problem is where individuals will be better off cooperating to minimise the cost of an action but fail to do so.

Question 10

advanatages of social networks

Answer 10

• lower cost of organising collective action, can help to organise protest movements and share information