Unit 6 - The Firm: Owners, Managers, and Employees

Question 1

The division of labour is coordinated in two major ways

Answer 1

1. Firms
   –> the components of goods are produced by different people in different departments of a firm
2. Markets
   –> components produced by groups of workers in different firms are brought together through market interactions + by buying and selling goods on markets, the product gets from the producer to the consumer

Question 2

outsourcing

Answer 2

Outsourcing is a business practice in which a company hires a third party to perform tasks, handle operations or provide services for the company.

Question 3

Firms coodination of power

Answer 3

• concentration of economic power
• Economic power is in the hands of the owners and managers - they issue directives with the expectation that their employees will carry them out

Question 4

Markets coordination of power

Answer 4

• decentralised form of economic power
• Purchases and sales result from the buyers and sellers autonomous decisions
• Price mechanism and market pressures

Question 5

Asymmetric flow of information

Answer 5

Owners and managers do not always know what their subordinated know or do, not all of their directions or commands are necessarily carried out

Question 6

Features of the firm

Answer 6

• a miniature, privately owned, centrally planned economy
• The distinguishing feature of firms is the suppression of the price mechanism - it works with orders and commands
• labour wage contracts

Question 7

contracts

Answer 7

• A contract is a legal document or understanding that specifies a set of actions that the parties to the contract are to undertake
• • Contracts for goods sold in markets transfer ownership of the good from the seller to the buyer.
• Contracts for labour grant authority to direct the activities of the firm’s employee from the employee to the manager or owner.

Question 8

similarities and differences of firms and markets

Answer 8

1. type of contracts: labour wage (temporarily) or goods (permanently) contract
2. firm specific assets –> working in a firm means accumulating firm-specific assets that will be lost if the connection to the firm is severed. Relationships with buyers/networking
3. social interactions: in firms sometimes extend over decades, or even a lifetime and in markets contacts are typically short lived and not repeated.
4. Power: Working in a firm, unlike buying or selling products in a market, means engaging in a relationship in which some individuals have the power to issue orders to others, with the expectation that those orders will be carried out.

Question 9

residual claimants

Answer 9

The residual claimant receives the remainder of the sum after all costs have been accounted for.

Question 10

separation of ownership and control

Answer 10

• The firms profits legally belong to the people who own the firms assets
• The owners take whatever remains after revenues are used to pay employees, managers, suppliers, creditors and taxes
• Profit is the residual, it is what is left of the revenues after these payments
• The owners claim to it makes them residual claimants

–> this can lead to a conflict of interest since the owners profit from the managers hard work etc.

Question 11

owners are shareholders

Answer 11

• By issuing shares to the public as well, the company can raise capital finance
• The use of others people funds leads to the separation of ownership and control
  –> leads to principal agent problems

Question 12

principal agent problem

Answer 12

• differing interests/objectives of managers and shareholders
• free riding problems

Question 13

A firms profit depends on

Answer 13

• Costs of acquiring the inputs necessary for the production process
• Output
• Sales revenues received from selling goods or services

–> firms seek to minimize the cost of acquiring the necessary labour to produce the goods and services they sell

Question 14

problems when hiring

Answer 14

A firms cannot write an enforceable employment contract that specifies the exact tasks employees have to perform in order to get paid

Question 15

employment contract

Answer 15

omits things that both the employees and the business owners care about: how hard and well the employee will work, and for how long the workers will stay

Question 16

contractual incompleteness

Answer 16

• It may be costly for the firm if the employee leaves, but employees retain the right to do so.
• Since the firm does not know all the tasks it will require of an employee, the contract is necessarily incomplete.
• Since effort or the quality of an individual’s work cannot be perfectly monitored and measured, it cannot be specified in the contract.

Question 17

piece rate

Answer 17

paying employees based on how productive they are - this method incentivizes employees to put in effort

Question 18

Limitations of piece rate salaries

Answer 18

• It’s very difficult to measure the amount of output an employee is producin in modern knowledge and service-based economies
• Employees rarely work alone, so measuring the contribution of individual workers is difficult

Question 19

Employment rent

Answer 19

the difference between the value of the job (taking into account all the benefits and costs it entails) and the value of the next best option (being unemployed and having to search for a new job)

Question 20

benefits of employment rent

Answer 20

1. The employee is more likely to stay with the firm: If she were to quit the job, the firm would need to pay to recruit and train someone else.
2. They can threaten to fire the worker: Owners and managers exert power over employees because the employee has something to lose. The threat can be implicit or explicit, but it will make the worker perform in ways that she would not choose unless this was the case.

–> The main reason owners hold power over managers is that they can fire them, and so eliminate their managerial employment rents

Question 21

Counting the cost of job loss

Answer 21

• Economic rent - the value of a situation (current job) compared to the alternative if the current situation were no longer possible
• Employment rent (the net cost of job loss) - weigh up all the benefits and costs of working compared with being unemployed and searching for another job
• Costs of working

–> The disutility of work - spending time working on things that one would prefer not to do
–> The cost of traveling to work every day

• Benefits of working

–>Wage income - can be offset by an unemployment benefit or self-employment work
–>Firm-specific assets - such as workplace friends
–>Medical insurance - or other fringe benefits
–>The social status of being employed

Question 22

determinants of employment rent

Answer 22

1. The pay - something valuable
2. How hard she works

Question 23

utility

Answer 23

Maria’s utility is increased by the goods and services she can buy with her wage, but reduced by the unpleasantness of going to work and working hard all day—the disutility of work.

Question 24

disutility of work

Answer 24

Disutility of work depends on how much effort she puts into her job

Question 25

Formula of net utility per hour

Answer 25

Net utility per hour = wage - disutility of effort per hour

Question 26

Formula for total employment rent

Answer 26

Total employment rent = employment rent per hour x expected lost hours of work (time in which one is unemployed)

Question 27

Reservation wage

Answer 27

the lowest wage that would induce her to accept a job in which she did not experience any disutility of work (for example receiving an unemployment benefit

The wage at which one is willing to forgo unemployment benefits for a job - is indifferent between being unemployed or employed - a change in the disutility of effort would have no effect

Question 28

Formula for the reservation wage

Answer 28

Reservation wage = unemployment benefit - disutility of unemployment

Question 29

Formula for employment rent per hour

Answer 29

Employment rent per hour = wage - reservation wage - disutility of effort + disutility of unemployment

Question 30

labor discipline model

Answer 30

• When the employment rent is large - workers will be willing to work harder in order to reduce the likelihood of losing the job

–> firms influence the employment rent (the cost of job loss) by raising wages

Question 31

the employers best reponse curve

Answer 31

• Increasing wage will increase the likelihood of the employee keeping their job, and the employment rent
• The employee needs to find the balance between this and the effort they put into the job
• A higher wage increases the employment rent and hence the benefit from effort, so it will lead her to choose a higher level of effort

Question 32

best response curve

Answer 32

the effort chosen by the employee for each level of wage (like the production functions, it shows how one variable - here, effort - depends on another - here, wage)

1. Diminishing marginal returns - at higher levels of wages, increases in wages have a smaller effect on effort
2. The slope of the best response curve - the employer’s MRT of higher wages into more worker effort
3. As the level of effort approach the max - the disutility of effort increases - it takes a larger employment rent (and therefore a higher wage) to get effort from the employee
4. The fact that the best response curve slopes upward means that employers face a trade-off

Question 33

to maximise profits

Answer 33

To maximise profits, the employer should find a feasible combination of effort and wage that minimises the cost per unit of effort

–> isocost line for effort

Question 34

to minimise costs

Answer 34

• the employer will seek to reach the steepest isocost line for effort, where the cost of a unit of effort is lowest
• But because the employer cannot dictate the effort, they must pick some point on the employee’s best response curve

Question 35

the isocost line for effort

Answer 35

• the ratio of effort to wages
• The line slopes upward because a higher effort level must be accompanied by a higher wage for the e/w ratio to remain unchanged
• Cost of effort - wage/effort
• The slope of the isocost line for effort - the MRS - the rate at which the employer is willing to increase wages to get higher effort

Question 36

efficiency wage equilibrium of a worker and a firm

Answer 36

• The employer minimises costs and maximises profit at the point where his MRS equals MRT
• Here the employer also balances the trade-off between wages and effort against the trade-off of profit

Question 37

efficiency wages

Answer 37

• employer recognises that what matters is the efficiency units per dollar of wage costs, rather than how much an hour of work costs
• What matters for profits is effort/wage

Question 38

labour discipline model

Answer 38

A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination.

Question 39

What has the labour discipline model told us?

Answer 39

Equilibrium - In the owner-employee game, the employer offers a wage and Maria provides a level of effort in response. Their strategies are a Nash equilibrium.

Rent - In this allocation Maria provides effort because she receives an employment rent that she might lose if she were to slack off on the job.

Power - Because Maria fears losing this economic rent, the employer is able to exercise power over her, getting her to act in ways that she would not do without this threat of job loss. This contributes to the profits of the employer.

Question 40

involuntary unemployment

Answer 40

• Not having a job, although you would be willing to work at the wage that other workers like you are receiving
• In equilibrium, both wages and involuntary unemployment have to be high enough to ensure that there is enough employment rent for workers to put in effort

Question 41

when will the best response curve shift?

Answer 41

• the utility of the things that can be bought with the wage
• the disutility of effort
• the reservation wage
• the probability of getting fired when working at each effort level

Question 42

a worker-owned cooperative

Answer 42

• the workers are the owners of the capital goods and other assets of the company, and they select the managers who run the company on a day-to-day basis
• Every employee is a partner, amd employee councils elect five out of seven members of the company board
• Hierarchically organised but the directives issued from the top of the hierarchy come from people who owe their jobs to the worker-owners
• Inequalities in wages and salaries within the company, for example between managers and production workers, are also typically less in worker-owned cooperatives than in conventional firms

Question 43

several reasons for the absence of a complete contract

Answer 43

Information is not verifiable: For a contract to be enforceable, relevant information must be observable by both parties, but also verifiable by third parties such as courts of law.

Time and uncertainty: A contract is generally executed over a period of time, for example specifying that Party A does X now and Party B does Y later.

Measurement: Many services and goods are inherently difficult to measure or describe precisely enough to be written into a contract.

Absence of a judiciary: For some transactions there are no judicial institutions (courts or other relevant third parties) capable of enforcing contracts. Many international transactions are of this type.

Preferences: Even where the nature of the goods or services to be exchanged would permit a more complete contract, a less complete contract might be preferred.

Question 44

hidden action problem