Size and Structure of Firms Flashcards
Efficiency for firm
Efficiency motives are those associated with minimising costs or maximising producer surplus in a way that may also be socially beneficial, that is increase total social welfare. The efficiency of a certain organisational form refers then here primarily to the firm or firms involved, not necessarily to society as a whole
Explanations for the size and structure
Efficiency explanations
Market Power motives
Efficiency explanations
the technological view of the firm
transactions costs-property rights approach
Technological view
optimal firm size and diversification
depend on the degree of economies of scale and scope.
Technological constraints are important, but they are not the whole story
Problems with technological view
1) It is not clear why the AC curve rises at high output. If producing quantity qA + qB were to cost more than producing qA and qB separately, why can’t there be a single firm that consists of two independent divisions producing qA and qB respectively?
2) The technological view of the firm may explain the joint use of facilities, but not joint ownership. Why can’t agents write contracts to exploit economies of scale and scope without joint ownership?
Transaction costs-property rights approach idea
the choice between organising activity internally and using the market (or contracts) is determined by a comparison of the costs and
benefits of these two modes of organisation
Economic factors that matter for choice of internal/external
1) Investment specificity
2) Opportunistic behaviour
3) Bounded rationality
relationspecific
investments
investments that pay off a maximum return only if the particular relationship continues for some time. Examples of specificity are site specificity (e.g. a firm builds a plant next to another firm’s works to save on transport costs); physical asset specificity (e.g. a firm designs equipment with characteristics specific to a
particular order); and human capital specificity (e.g. an employee invests in acquiring skills which are specific to a certain job).
ex ante/ex post
ex ante competitive situation
ex post bilateral monopoly
Problems because of holdups
1) The level of trade ex post may not be efficient if there is asymmetric
information. This can occur irrespective of whether the relation
involves ex ante investments or not.
2) The level of investment ex ante will not be efficient, even under symmetric information. The reason is that once a party has sunk the cost of the investment, it has lost any extra bargaining power. So even if the efficient volume of trade occurs ex post, the division of the
surplus will be such that the level of investment ex ante is not efficient.
Problems because of holdups
1) The level of trade ex post may not be efficient if there is asymmetric information. This can occur irrespective of whether the relation involves ex ante investments or not. (buyer value ~f(v))
2) The level of investment ex ante will not be efficient, even under symmetric information. The reason is that once a party has sunk the cost of the investment, it has lost any extra bargaining power. So even if the efficient volume of trade occurs ex post, the division of the
surplus will be such that the level of investment ex ante is not efficient. c(I) model with underinvestment
Bounded rationality
a complete contract is often impossible to
write
transaction costs approach prediction
the more specific the investment, the larger the scope for efficiency losses due to opportunistic behaviour. Hence the more specific the investment, the higher the probability of integration (i.e. common ownership) as opposed to a contractual relationship.
transaction costs approach prediction
the more specific the investment, the larger the scope for efficiency losses due to opportunistic behaviour. Hence the more specific the investment, the higher the probability of integration (i.e. common ownership) as opposed to a contractual relationship.
Why underinvestment happens if there is ex post bargaining
Since the ex post surplus is divided between the
two parties, the investing party does not capture all the cost savings from
its investment. This ‘distortion’ of incentives leads to underinvestment.
residual right of control
owner of the physical asset(s) who has this right, the residual right of control. Ownership’ is defined as the right to specify all usages of these assets in any way not inconsistent with a previous contract, custom or law.
puts the party into better bargaining position ex post
conclusions have emerged from the property rights approach
1) Integration reduces opportunistic behaviour because if, say, firm A acquires firm B, then the manager of firm B loses control of the physical assets of firm B, so he has much less bargaining power.
2) In a merger it matters which of the parties has residual rights of control within the merged firm (i.e. it matters who acquires whom).
3) A party is more likely to own, and hence have control over, an asset if it has a large investment to make. In other words, efficiency requires that the residual rights of control rest with the party whose ex ante investment has the larger effect on the joint profit.
4) Efficiency requires that highly complementary assets are under common ownership. On the other hand, independent assets should be separately owned: there are limits to integration. Why? If firm A acquires firm B, for example, then the manager of firm B will have
much lower incentives to undertake investments since the payoff from these will be partly appropriated by the owner of firm A. So if assets are independent, the costs of integration (in terms of underinvestment by the manager of firm B) will be higher than any potential benefits.
conclusions have emerged from the property rights approach
1) Integration reduces opportunistic behaviour because if, say, firm A acquires firm B, then the manager of firm B loses control of the physical assets of firm B, so he has much less bargaining power.
2) In a merger it matters which of the parties has residual rights of control within the merged firm (i.e. it matters who acquires whom).
3) A party is more likely to own, and hence have control over, an asset if it has a large investment to make. In other words, efficiency requires that the residual rights of control rest with the party whose ex ante investment has the larger effect on the joint profit.
4) Efficiency requires that highly complementary assets are under common ownership. On the other hand, independent assets should be separately owned: there are limits to integration. Why? If firm A acquires firm B, for example, then the manager of firm B will have
much lower incentives to undertake investments since the payoff from these will be partly appropriated by the owner of firm A. So if assets are independent, the costs of integration (in terms of underinvestment by the manager of firm B) will be higher than any potential benefits.
mechanisms to limit managerial discretion
1) The threat of takeovers (stock price falls, takeover)
2) Reputation effects (care for career)
3) Supervision (costly but feasible monitoring, danger of collusion)
4) Competition in product market (not able to compete -> become bankrupt)
5) Organisational form (multi-divisional form - top management can measure the performance)
Profit maximisation happens?
we should expect deviations from profit maximisation due to the separation of ownership and control. If we accept, as many economists do, that large deviations from profit maximisation will probably not allow a firm to survive in the long run, then the hypothesis that firms maximise expected profits seems a reasonable approximation of firm behaviour for most purposes, and in particular for the analysis of the interaction between firms in the market, which is the main focus of industrial economics.
