1 Coase, Theory of the Firm, Tirole chapter 0 Eric Rasmusen, [email protected] [email protected] G604, Tirole-Coasle, size of firms, 14 November,

11

Coase, Theory of the Firm, Coase, Theory of the Firm, Tirole chapter 0Tirole chapter 0 Eric Rasmusen, Eric Rasmusen, [email protected]@Indiana.edu

G604, Tirole-Coasle, size of firms, 14 November, 2006

I decided it is better to teach mostly with the whiteboard, not slides, so these arenow just my notes and a few things like the Coase quotes that I project up.

22

• Classics: OrganizationClassics: Organization         R. H. R. H. CoaseCoase (1937) (1937) "The Nature of the Firm,""The Nature of the Firm," Economica, Economica, New Series,New Series, 4, 16: 386-405 4, 16: 386-405 (November 1937) (November 1937)

        Let’s talk about Coase as an Let’s talk about Coase as an introductionintroduction

to the problem of “What is a firm?”to the problem of “What is a firm?”

33

Coase (1937)Coase (1937)

44

Transaction CostsTransaction Costs

55

Using MarginalismUsing Marginalism

66

Master and ServantMaster and Servant

• The last part of Coase is about The last part of Coase is about authority. The principal commands authority. The principal commands the agent. the agent.

• Why is the principal the entrepreneur Why is the principal the entrepreneur and not the worker? (not in Coase)and not the worker? (not in Coase)

• Why does the residual claimant have Why does the residual claimant have the authority? (not in Coase)the authority? (not in Coase)

77

Three ViewsThree Views

• Technological-Production FunctionTechnological-Production Function

• Contractual-Nexus of ContractsContractual-Nexus of Contracts

• Incomplete Contracts—AuthorityIncomplete Contracts—Authority

88

The Technological ViewThe Technological ViewAvoiding competition (horizontal merger)Avoiding competition (horizontal merger)Avoiding overly high prices for complementary products (not Avoiding overly high prices for complementary products (not

in Tirole)in Tirole)Allowing vertical price discrimination (ch 3)Allowing vertical price discrimination (ch 3)

Economies of Scale (Economies of massed reserves, Economies of Scale (Economies of massed reserves, economies of scale from spreading fixed costs) (shape of economies of scale from spreading fixed costs) (shape of cost curves) (natural monopoly)cost curves) (natural monopoly)

Economies of scopeEconomies of scope

Avoiding sales taxAvoiding sales tax

99

TiroleTirole

• p. 20. Why do economies of scale p. 20. Why do economies of scale have to be exploited have to be exploited withinwithin the firm? the firm?

• This relates to Coase (1937)This relates to Coase (1937)

1010

Why Not One Big Firm?Why Not One Big Firm?

Williamson’s Puzzle of Selective Intervention: Williamson’s Puzzle of Selective Intervention: why not merge two firms and then manage why not merge two firms and then manage them just the same as before? (p. 21)them just the same as before? (p. 21)

One answer: we cannot contract to make One answer: we cannot contract to make the CEO of each firm a residual claimant. the CEO of each firm a residual claimant.

Think of Holmstrom’s Teams model (1982). Think of Holmstrom’s Teams model (1982).

Rasmusen and Zenger, Rasmusen and Zenger, ``Diseconomies of Scale in ``Diseconomies of Scale in Employment Contracts,'' Employment Contracts,'' Journal of Law, Economics and Journal of Law, Economics and Organization Organization (June 1990), 6(1): 65-92 . (June 1990), 6(1): 65-92 .

1111

Bargaining Power Bargaining Power (Rasmusen)(Rasmusen)

Two possible meanings: Two possible meanings:

1. The threat point (Apex gets 2, Brydox 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets gets 8) vs. (Apex gets 7, Brydox gets 3) 3)

2. The division of surplus (Apex gets 2. The division of surplus (Apex gets 100%, Brydox gets 0%) vs. (Apex 100%, Brydox gets 0%) vs. (Apex gets 20%, Brydox gets 80%) gets 20%, Brydox gets 80%)

1212

Bargaining: Why the Coase Bargaining: Why the Coase Theorem Breaks Down (pp. 22-Theorem Breaks Down (pp. 22-

24)24)(1) Possible pre-asymmetric info moves(1) Possible pre-asymmetric info moves(2) Nature chooses buyer value v using density f(v) on [a,b] with (2) Nature chooses buyer value v using density f(v) on [a,b] with

seller cost c in (a,b). The buyer observes this. seller cost c in (a,b). The buyer observes this. (3) The seller, with cost c, offers price p to the buyer. (3) The seller, with cost c, offers price p to the buyer. (4) The buyer accepts or rejects. (4) The buyer accepts or rejects.

This leads to inefficiency–-the Myerson-Satterthwaite problem.This leads to inefficiency–-the Myerson-Satterthwaite problem.

Seller proposing an offer at (1) would not help. Seller proposing an offer at (1) would not help.

Merging at (1) Merging at (1) wouldwould help. So we should put buyer and seller in the help. So we should put buyer and seller in the same firm.same firm.

OR: give all the bargaining power to the informed party, e.g. the OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller and gives contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price p=c (an option the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism (footnote 29)contract) OR use a fancy mechanism (footnote 29)

1313

Asset Specificity/The Hold-Up Asset Specificity/The Hold-Up Problem (p. 24)Problem (p. 24)

(1) The buyer value is v=3. The seller can invest 2 to get c=0 (1) The buyer value is v=3. The seller can invest 2 to get c=0 or not invest, to keep c=4. or not invest, to keep c=4.

(2) The buyer offers price p to the seller. (or, use 50-50 split)(2) The buyer offers price p to the seller. (or, use 50-50 split)(3) The seller accepts or rejects. (3) The seller accepts or rejects.

This leads to investment of 0. This leads to investment of 0.

The buyer proposing an offer at (0) *would* help. The buyer proposing an offer at (0) *would* help.

Merging at (0) would help too. So we should put buyer and Merging at (0) would help too. So we should put buyer and seller in the same firm.seller in the same firm.

OR: give all the bargaining power to the investing party, i.e. OR: give all the bargaining power to the investing party, i.e. the seller here. the seller here.

1414

Asset Specificity/The Hold-Up Asset Specificity/The Hold-Up Problem Example (p. 28)Problem Example (p. 28)

Joskow found that when coal quality is Joskow found that when coal quality is diverse, not many transportation diverse, not many transportation methods, and few mines, then methods, and few mines, then long-term contracts will be used long-term contracts will be used (West US)(West US)

In the opposite case, short-term In the opposite case, short-term contracts (spot markets) are used contracts (spot markets) are used (East US)(East US)

1515

Authority (p. 30)Authority (p. 30)

• Authority changes the threat point in Authority changes the threat point in bargaining. It changes, in a sense, bargaining. It changes, in a sense, bargaining power. bargaining power.

• Think of the UN Security Council. Think of the UN Security Council. Suppose Russia and France do not care Suppose Russia and France do not care about Rwanda policy, but the US does. about Rwanda policy, but the US does. Is the effect of giving them veto power Is the effect of giving them veto power over US policy to change US policy? over US policy to change US policy?

1616

Unconstrained Bargaining (pp. Unconstrained Bargaining (pp. 31-32)31-32)

(0) The buyer and seller have made a basic contract.(0) The buyer and seller have made a basic contract.(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new

feature that will cost the seller c to produce. feature that will cost the seller c to produce. (2) The buyer value of the new feature is v>c with (2) The buyer value of the new feature is v>c with

probability x and 0 otherwise.probability x and 0 otherwise.(3) Buyer and seller bargain for a price p for (3) Buyer and seller bargain for a price p for

the feature. If they disagree, the new the feature. If they disagree, the new feature is not added to the product.feature is not added to the product.

Assume: bargaining splits the gains from agreement. Assume: bargaining splits the gains from agreement.

Result: UnderinvestmentResult: Underinvestment

1717

Seller Has Authority to Make Seller Has Authority to Make Changes ( p. 32)Changes ( p. 32)

(0) The buyer and seller have made a basic contract.(0) The buyer and seller have made a basic contract.(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new

feature that will cost the seller c to produce. feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with (2)The buyer value of the new feature is v>c with

probability x and 0 otherwise.probability x and 0 otherwise.(2.5) The seller decides whether to add the new (2.5) The seller decides whether to add the new

feature to the product. The buyer can pay feature to the product. The buyer can pay him to make him do it. him to make him do it.

Assume: bargaining splits the gains from agreement. Assume: bargaining splits the gains from agreement.

Result: UnderinvestmentResult: Underinvestment

1818

Buyer Has Authority to Make Buyer Has Authority to Make Changes ( pp. 32-33)Changes ( pp. 32-33)

(0) The buyer and seller have made a basic (0) The buyer and seller have made a basic contract.contract.

(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new feature that will cost the seller c to produce. feature that will cost the seller c to produce.

(2)The buyer value of the new feature is v>c with (2)The buyer value of the new feature is v>c with probability x and 0 otherwise.probability x and 0 otherwise.

(2.5) The buyer decides whether to add the (2.5) The buyer decides whether to add the new feature to the product, possibly being new feature to the product, possibly being paid by the seller not to require it. paid by the seller not to require it.

Assume: bargaining splits the gains from Assume: bargaining splits the gains from agreement.agreement.

Result: OverinvestmentResult: Overinvestment

1919

What if the New Feature Might What if the New Feature Might Be Actually a Worsening for Be Actually a Worsening for

the Buyer?the Buyer?• We can run that model with We can run that model with

probability x of value v>c and probability x of value v>c and probability (1-x) of value –y<0 too. probability (1-x) of value –y<0 too.

• Then, buyer authority does not result Then, buyer authority does not result in overinvestment, I think--- for in overinvestment, I think--- for reasons elucidated in Lyon and reasons elucidated in Lyon and Rasmusen (2004) Rasmusen (2004)

2020

Lyon-Rasmusen (2004)Lyon-Rasmusen (2004)

• Thomas P. Lyon, Eric Rasmusen. ``Buyer-Option Contracts, Renegotiation, Thomas P. Lyon, Eric Rasmusen. ``Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'' Journal of Law, Economics and and the Hold-Up Problem,'' Journal of Law, Economics and Organization,20,1 (Spring 2004).Organization,20,1 (Spring 2004).

• Hart & Moore (1999) construct a model to show that Hart & Moore (1999) construct a model to show that contracts perform poorly when the state of the world is contracts perform poorly when the state of the world is unverifiable and renegotiation cannot be ruled out. They unverifiable and renegotiation cannot be ruled out. They implicitly assume that one player can extort payment from implicitly assume that one player can extort payment from another by threatening to take an inefficient action which another by threatening to take an inefficient action which hurts both of them. Without this assumption, a simple hurts both of them. Without this assumption, a simple ``buyer option" contract can implement the first- best even ``buyer option" contract can implement the first- best even as complexity becomes severe. The model is a good as complexity becomes severe. The model is a good illustration of the need to be careful with the ideas of ``one illustration of the need to be careful with the ideas of ``one party has all the bargaining power'' and ``one party can party has all the bargaining power'' and ``one party can make a take-it-or-leave-it offer.''make a take-it-or-leave-it offer.''

2121

More Variants on the Hold-Up More Variants on the Hold-Up Game Game

• Holdup 4: Seller sets price. Buyer MAY buy. (Buyer may Holdup 4: Seller sets price. Buyer MAY buy. (Buyer may not buy anywhere else)not buy anywhere else)

• Holdup 5: Set a price in advance, and buyer MAY buy if Holdup 5: Set a price in advance, and buyer MAY buy if seller is willing. seller is willing.

• Holdup 6: Set a price in advance, and buyer MAY buy even Holdup 6: Set a price in advance, and buyer MAY buy even if seller is unwilling. if seller is unwilling.

• Holdup 7: Set a price in advance, and buyer MUST buy if Holdup 7: Set a price in advance, and buyer MUST buy if seller is willing. seller is willing.

• Variant on the game: Variant on the game: • Seller can produce a good of low quality, with value 0, if Seller can produce a good of low quality, with value 0, if

he fails to invest. What does that imply for Contracts 1,2,3, he fails to invest. What does that imply for Contracts 1,2,3, 4, 5, 6, and 7? 4, 5, 6, and 7?

2222

2323

A link to the course websiteA link to the course website

http://www.rasmusen.org/g604/0.g604.http://www.rasmusen.org/g604/0.g604.htmhtm