Week 11 Flashcards
The firm
A planning unit which produces goods (outputs) using factors of production (inputs) for financial return
The economics of organisation looks inside the “black box” of the firm.
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Problems with the traditional approach
why do firms exist at all?
How are they internally organised?
What determines their boundary ?
5 Assumptions of traditional economics
Perfect rationality and information
Profit maximisation
Identical costs and profits
One single and identical product
Zero transaction cost
Reality of Perfect rationality and information
Firms are evolving hierarchies of procedures to process information
Reality of Profit maximisation
Firms are coalition of stakeholders with different, conflicting objectives
Reality of Identical costs and profits
Firms are bundles of resources of different quality which determine their success which differs between firms and over time
Reality of One single and identical product
Firms make a number of products at different stages of the production process.
Reality of Zero transaction cost
Firms are command and control mechanisms that internalise market transactions
The firms boundary
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The firms boundary definition
Defines what the firm does
Vertical chain
All steps that need to be carried out in order to produce a good or service
Vertical Boundary
identifies the activities on the vertical chain which the firm carries out itself internally, instead of acquiring from the market (the make or buy decision)
Horizontal boundary
identifies how much of the product market the firm serves (the quantities and varieties of its products and services) - essentially, its size
Transaction costs
The costs of using the market i.e. the costs that parties incur in the process of agreeing and following through on an exchange.
Transactions involve
Identifying trading partners
Negotiating contracts
Monitoring compliance
Enforcing fulfilment
Transactions are costly due to
Bounded rationality
Opportunism/moral hazard
Firms are command-and-control mechanisms
Firms are command-and-control mechanisms that can internalise transactions when carrying them out within the firm is cheaper than in the market.
Firm integration
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Vertical integration
When the firm expands its vertical boundary. The firm decides whether to carry out a transaction along the vertical chain in inhouse (backward or forward integration) or in the market (outsourcing) based on where it can be done at lower transaction cost (make or buy decision).
Make or buy decision
a list of factors to consider – they may not always point in the same direction – need to balance them out
a list of factors to consider – they may not always point in the same direction – need to balance them out
Economies of scale and scope
Number of firms
Asset specificity
Firm specific knowledge
Uncertainty
Scope for opportunism
Monitoring/governance costs
Complexity of production
Make or buy decision
Starbucks example
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Horizontal integration
When the firm expands its horizontal boundary. The firm decides how much of the product market to serve in terms of quantity and variety based on economies of scale and scope as well as strategic reasons.
Economies of scale
Horizontal integration
Cost per unit of output falls as scale (quantity) of production increases.
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Real economies
Horizontal integration
changes in input quantities as a result of volume
Indivisibilities of fixed assets
Alternative production techniques
Specialisation
Inventories
Pecuniary economies
Horizontal integration
changes in prices paid by the firm for inputs
Purchasing power
Advertising
R & D
Diseconomies
Horizontal integration
Higher wages and unionisation
Incentivisation and monitoring
Red tape: communication and coordination difficulties
Specialised resources spread too thin
Horizontal integration
Learning economies
Cost per unit of output falls due to accumulating experience and know how over time
Learning economies vs. economies of scale
Can be substantial when economies of scale are minimal, absent (e.g., in complex, labour intensive industries) and vice versa (e.g., in simple, capital intensive industries)
Failure to recognise the difference may lead to incorrect judgment about the benefits of size
Horizontal integration
Economies of scope
Cost per unit of output falls as variety of production increases. The combined production of two or more separate products costs less than the total of their individual production.
Sources of economies of scope
Indivisibilities: under-utilised fixed assets
Core competences: firm-specific assets
Networks: customers, suppliers, contacts with banks, government
Brand name: exploit customer loyalty
The factors of production
FOP are the inputs used by the firm to produce outputs (goods and services).
The 3 FOP categories
Labour - the FOP which comprises the human input;
Land – the FOP that are created by nature;
Capital - the FOP that are man made, i.e. have themselves been produced
The factors market - Introduction
The prices paid by firms to households for these FOPs are wages, rent and profit/interest for labour, land and capital respectively.
In many ways, factors markets resemble goods markets.
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Labour market imperfections and wage differentials
The perfectly competitive labour market generates a single market-clearing equilbrium wage (W) for all workers.
In reality, wages differ between different types of workers and there is unemployment. The reason lies in certain imperfections of the labour market:
Assumptions of the labour market:
The firms hiring workers sell their goods in a • perfectly competitive market.
The labour market has lots of buyers (firms) and sellers (workers), and is therefore perfectly competitive.
Workers are homogeneous (i.e. undifferentiated).
Wages are flexible (no transactions cost).
11.3 Labour market imperfections and wage differentials
When broken diagram
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. Labour differentiation: compensating differentials
Compensating differential is the difference in wages that arises to offset the non-monetary characteristics of different jobs. In many cases compensating differentials explain why people with similar levels of education earn different wages.
. Labour differentiation: compensating differentials
Examples
Miners are paid more than other workers with similar levels of education. Their higher wage compensates them for the dirty and dangerous nature of mining.
Workers who work the night shift at factories are paid more than similar workers who work the day shift.
University lecturers are paid less than lawyers and doctors, who have similar amounts of education. Lower wages compensate them for the intellectual and personal satisfaction that their jobs offer.
11.3.1. Labour differentiation: human capital
Human capital is the accumulation of investments in people, such as education and on the job training. The most important type of human capital is education.
Education and human capital
Education represents an expenditure of resources at one point in time to raise productivity in the future.
An investment in education is tied to a specific person, it is therefore called human capital.
Human capital and higher productivity
Firms are willing to pay more for workers with more human capital because they have higher productivity.
When people get a university degree, they signal their high ability to prospective employers. Because it is easier for high-ability people to get a degree than for low-ability people, more high-ability people get degrees. As a result, it is rational for firms to interpret a degree as a signal of ability.
Most likely, education produces a combination of productivity-enhancing effects (human capital) and
productivity-revealing effects (signaling).
Labour differentiation
Natural ability
Natural ability is important for workers in all occupations. Because of heredity and upbringing, people differ in physical and mental attributes that determine how productive they are.
Labour differentiation
Effort
Closely related to ability is effort. Some people work hard, others are lazy. We should not be surprised to find that those who work hard are more productive and earn higher wages.
Labour differentiation
Chance
Chance also plays a role in determining wages. A person who trained to manufacture cars just before the car industry shut down will end up earning a low wage compared with others with similar years of training.
Labour differentiation: discrimination
Discrimination is the offering of different opportunities to similar individuals who differ only by race, ethnic group, sex, age or other personal characteristics. Discrimination reflects some people’s prejudice against certain groups in society.
Wage differentials and discrimination
Some observed wage differentials may be attributable to discrimination, but there is no consensus about how much. Even in a labour market free of discrimination, different people may have different wages due to compensating differentials, human capital, ability, etc.
However, differences in human capital among groups of workers may reflect earlier discrimination
(e.g. inferior access to education and health during childhood).
Imperfect competition: the superstar phenomenon
Although most actors earn very little and often have to take jobs as waiters to support themselves, the best actors earn millions of dollars for each film they make. What explains the difference
Superstars arise in markets that have two characteristics:
Every customer in the market wants to enjoy the good supplied by the best producer; and
The good is produced with a technology that makes it possible for the best producer to supply every customer at low cost.
. Imperfect competition: efficiency wages
Efficiency wages are above equilibrium wages paid by firms in order to increase worker productivity.
Because efficiency wages are above the wages that would result when supply equals demand, they can potentially explain unemployment as well as earnings.
They are offered to improve health, productivity, decrease turnover, encourage effort and attract higher quality workers.
