The Nature of the Firm

Invisible Hand

• The use of market (price) mechanism in allocating resources or goods.

• Buyers and sellers trade directly with each others.

P

Q

S

D

Visible hand

• The use of the entrepreneur in directing the allocation of resources (or goods).

A Firm

• An organization in which the use of resources is directed by a manager (director) (i.e. directed by a visible hand), instead of being directed by the invisible hand of the market mechanism (i.e. directed by signals of the market price).

Does a Firm exist?

• A boy provides shoe-shining service in the street.

• It depends on whether the boy is directed by somebody to shine shoes in the streets.

Does a Firm exist?

• A father orders his son to clean up the floor after a party.

• Yes

Does a Firm exist?

• A housewife buys some fresh seafood in the market and some cooked food from fastfood shop.

• Yes/No

Have you ever tried seafood in Cheung Chau? You can have two options if you want to enjoy seafood dinner in Cheung Chau:

Questions

Option 1: Buy the seafood in the market and then

bring them to the restaurant. And the restaurant will cook the seafood for you, charging a ‘cooking fee’.

Questions

Like the restaurants in TST or Mongkok, you just walk into the restaurant and order the dishes you like, saving the trouble of buying seafood from the market by yourself.

Option 2:Questions

1.Why do some people prefer Option 1 while others do not?

Questions

2. If people can bring their own seafood to the restaurant, do you think it is possible to have a ‘chef’ market in which the chefs are self- employed to serve the customers, so that the customers will bring their own seafood plus a chef to the restaurant?

Questions

3.If people can bring their own seafood and chefs to the restaurant, why not bring their own tables, chairs, chopsticks, etc. ?

Questions

Past Paper Question

• “Whenever there is an employee, there is firm.” Do you agree? Explain. (86, 10 marks)

Firms Supersedes Market (Argument of Ronald Coase)

• There were costs of using the market mechanism (the costs of discovering what the relevant prices are).

• Costs:

(1) to discover the other party to deal with,

(2) to negotiate the terms of exchange,

(3) to draw up the contract,

(4) to enforce the contract.

Firms Supersedes Market (Argument of Ronald Coase)

Without firms, there will be multilateral contracts among individuals (buyers and resource owners) and high transaction costs incurred.

Firms Supersedes Market (Argument of Ronald Coase)

• If the costs (of using market) are prohibitively high, resources owners may choose to work under the direction of a visible hand (firm).

Why is using market costly? (Elaboration by Steven Cheung)

1. Contracting cost - without firms, the number of contracts is greater without firms.

Transactions Without Firms(When there is one consumer)

Cloth maker

designer

cutter

sewer

Consumer A

Transactions Without Firms(When there are 2 consumers)

Cloth maker

designer

cutter

sewer

Consumer A

Consumer B

Transactions Without Firms(When there are 3 consumers)

Cloth maker

designer

cutter

sewer

Consumer A

Consumer B

Consumer C

Transactions Without Firms(When there are 3 consumers)

12 product market

transactions

Transactions with the Existence of a Firm

Cloth maker

designer

cutter

sewer

Consumer A

Consumer B

Consumer C Firm

Transactions with the Existence of a Firm

3 factor market transactions4 product market transactions

• Factor market transactions • product market transactions • total no. of transactions

Why is using market costly? (Elaboration by Steven Cheung)

2. Information cost - consumers may have high information cost to recognize the different component parts of a product.

Why is using market costly?(Elaboration by Steven Cheung)

3. Measurement cost - it is costly to measure the characteristics or attributes of a productive activity (e.g. a clerk) a proxy

4. Cost of separating contributions (e.g. teamwork) a proxy on a take-it-or-leave-it basis

Firm Supersedes Market & the Optimal Size of a Firm

• The use of firm can reduce the costs of using the market mechanism.

“ Firm supersedes Market.”

• If the use of the firm can reduce the cost of using market, then

“Why don’t we have a super-firm to

organize all activities?”

Firm Supersedes Market & the Optimal Size of a Firm

• Coase: When a firm expands, the

administrative costs (transaction

costs) increase.

• A firm will expand until at the margin, the costs of organizing within a firm equal to:

(1) the cost of organizing in another firm;

(2) the cost of organizing through the market.

Firm Supersedes Market & the Optimal Size of a Firm

Communist State

• Can a communist state be regarded as a super-firm?

Firm supersedes market.

Coase

The Nature of Supersession

• The use of firm can reduce the costs of using the market mechanism.

“ Firm supersedes Market.” (R. Coase)

• Firm does not replace the market, instead it separates a market transaction into two -- factor market transaction vs. product market transaction.

“When we pay a shoe-shine boy to shine a pair of shoes for $10, the product market (the shine) and the factor market (the boy’s labour) are not separate markets and the firm does not exist.” Do you agree? Explain your answer by using what you know about the nature of the firm. (96, 8 marks)

Past Paper Question

Firm supersedes market.

Coase

Factor market supersedes product market.

Cheung

Firm product market transaction superseded by factor market transactions

Firm supersedes market.

Coase

Factor market supersedes product market.

Cheung

What is a firm?

?

It is futile to identify a “firm”, or say anything about the size of the firm.

Under the piece-rate contract, a worker joins factory (a firm), but is paid exactly according to the output he or she produces (using the price mechanism). Hence, we cannot say clearly whether the production is organized by the firm or through the price mechanism.

Price

Firm supersedes market.

Coase

Factor market supersedes product market.

CheungWhat is a firm?

One type of contract supersedes another type.

Cheung

Choice of organizational arrangements

Choice of contractual arrangements

1. Why do contracts take the form observed?

2. What are the economic implications of different contractual and pricing arrangement?

Cheung

Questions

Cheung

Choice of Contractual Arrangements

TeacherTaxi-driver

WaiterFilm director Salesperson

Tennis player

Different Cases:

Factory worker

Teacher

Wage Contract

A fixed amount paid to the factor owner on a specified time period.

Benefit: As a proxy is paid, the pricing and measuring contributions can be saved.

Cost: Workers tend to shirk and there will be high monitoring cost.

Piece-rate contract

Payment according to the amount of product produced.

Benefit: Workers have incentive to increase the output.

Cost: Workers pay less attention to the quality of output

Factory worker

Rental (fixed-rent) contract

A fixed amount paid by a lessee to the factor owner.

Benefit: The lessee will work very hard to maximize the residual income.

Cost: The depreciation rate and maintenance cost will be higher; higher monitor the factor provided by other owners.

Taxi-driver

Share contract

An agreed proportion on output is shared between the parties involved (e.g. employers and employees)

Benefit: Risk can be shared.

Cost: High costs to monitor inputs and to measure outputs.

Film director

Tips or gratitudes

Waiter

Commission

Salesperson

Prizes

Tennis player

Outright transfer contract

Helicopter

1. The employment of a teacher in a normal school, in a tutorial school.

Time-rate contract for a teacher in a normal school. Piece-rate contract for a teacher in a tutorial school.

2. A tourist guide

Time-rate contract plus tips

3. A salesman

Commission plus time-rate contract

Discussion

96(17) 14. Drivers of franchised (green) mini-buses are employed by mini-bus companies and are paid at time rate. However, taxi-drivers pay a fixed rent to taxi companies and take the residual income. There is such a difference because

A. the cost of pricing of mini-bus services is lower.

B. it is less costly for the government to contract with the mini-bus drivers.

C. the cost of monitoring mini-bus drivers is lower as the buses have fixed schedules and routes.

D. it is costly to count the number of passengers taking mini-buses.

4. A film director.

Share contract

5. The royalties to a book author if(a) the quantity of books sold is certain;(b) the income of books sold is certain.

(a) A percentage royalty (share contract)(b) A lump sum royalty

Discussion

The End