Week 7 - Firms

Question 1

What are firms?

Answer 1

A business organisation that employs labour, purchases inputs to produce market goods and services, and sets prices greater than the cost of production to make a profit.

Question 2

How does power distribution vary between firms and markets?

Answer 2

Firms - power is concentrated in the hands of the owners/managers
–> Owners decide on the long-term strategy of the firm
–> Managers implement long-term strategies through assigning tasks to workers and monitoring them

Markets - power is decentralised so decisions are autonomous and voluntary

Question 3

What is a contract?

Answer 3

A legal document or understanding that specifies a set of actions that parties to the contract must undertake

Question 4

What are the characteristics of relationships within a firm?

Answer 4

• long term
• creation of networks of colleagues
• skills, networks, and friendships are firm-specific assets
• when the relationship ends, value is lost to both sides

Question 5

Why might employee contracts be incomplete?

Answer 5

1. Some of the tasks an employee performs in the future cannot be predicted
2. Some aspects of the job are difficult to measure and base wages on

Question 6

How can we solve the problems of incomplete contracts?

Answer 6

Piece rate work - pay an employee a fixed amount per product produced
NOTE: this is difficult to do in the modern day where many products are now produced by complex teams

Question 7

What are some reasons employees might still work hard even if there is no Piece rate pay?

Answer 7

• don’t want to get fired
• feel accountable or responsible
• promotions
• employment rent

Question 8

What is employment rent?

Answer 8

The difference between the actual wages paid to an employee and the minimum wage or cost of looking for new work (ie unemployed).

Question 9

How does employment rent benefit employees and employers?

Answer 9

Employees - less likely to leave, encouraged to work harder

Employers - improves employee retention, can be used as a threat to fire a worker

Question 10

How do we calculate employment rent?

Answer 10

Employment rent/hr = wage - reservation wage - disutility of effort

Total Employment rent = Employment rent/hr x total hours of expected lost work time

Question 11

What factors can impact an employees incentive to supply effort?

Answer 11

1. the purchasing power of the wage (ie the utility that can be achieved with the wage)
2. the disutility of effort
3. the reservation wage
4. the probability of getting fired at each effort level
5. the level of unemployment

Question 12

What is the principal-agent model?

Answer 12

The employer is the principal and the employee is the agent and this model outlines the interactions between these two.