CH10: Nature of Firms
HKALE Economics
References:
Advanced Level Microeconomics, LAM pun-lee, CH 16
A-Level Microeconomics, CHAN & KWOK, CH 18
HKALE Microeconomics, LEUNG man-por, CH 15
CH10-Nature of Firms
By Mr. LAU san-fat
1
The Invisible Hand
Adam Smith: the principle of
"enlightened self interest“
Within the system of capitalism, an
individual acting for his own good tends
also to promote the good of his
community
CH10-Nature of Firms
By Mr. LAU san-fat
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The Invisible Hand
‘Every individual … generally neither intends
to promote the public interest, nor knows
how much he is promoting it... he intends
only his own gain, and he is in this, as in
many other cases, led by an invisible hand to
promote an end which was no part of his
intention.. By pursuing his own interest he
frequently promotes that of the society more
effectually than when he really intends to
promote it.’ (Adam Smith, The Wealth of Nations)
CH10-Nature of Firms
By Mr. LAU san-fat
3
The Invisible Hand
Any social benefits that have accrued
are simply a by-product of their striving
for selfish reward
Smith’s proposal is merely that in a free
market, people usually tend to produce
goods desired by their neighbours
CH10-Nature of Firms
By Mr. LAU san-fat
4
The Invisible Hand
Smith did not assert that all selfinterested labor necessarily benefits
society
The tragedy of the the commons is an
example where self-interest tends to
bring an unwanted result
CH10-Nature of Firms
By Mr. LAU san-fat
5
Transactions with Invisible Hand
Without a firm, a buyer has to make a
series of contracts with different
sellers/input owners directly for getting
what he wants.
Market participants respond sensitively
to market price signals in allocating
resources for maximizing their own
wealth.
CH10-Nature of Firms
By Mr. LAU san-fat
6
Transactions with Invisible Hand
To buy a product, a consumer has to
negotiate and deal with each sellers of
different product components.
To buy a product component, an
individual has to pay for that ‘product’
and the factor services involved
indivisibly.
CH10-Nature of Firms
By Mr. LAU san-fat
7
Transactions with Invisible Hand
Any invisible-hand-guided transaction
made implies that there is no way to
separate product market transaction
(PT) from factor market transaction
(FT).
CH10-Nature of Firms
By Mr. LAU san-fat
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The Visible Hand - Firm
A firm is characterized by having an
entrepreneur or manager who makes
contracts with and gives directions to
the input owner in the factor market,
and selling products to the buyer in the
product market.
CH10-Nature of Firms
By Mr. LAU san-fat
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Does a Firm Exist?
Does a firm exist when a boy
provides shoe-shinning service in
the street?
It depends on whether the boy is
directed by somebody to do the
shinning job.
CH10-Nature of Firms
By Mr. LAU san-fat
10
Why Firms Exist?
Argument 1: Specialization and
coordination

With increasing complexity of specialization
and division of labor, some integrating or
coordinating forces from the entrepreneur
are needed for preventing the economy
from collapsing into chaos.
CH10-Nature of Firms
By Mr. LAU san-fat
11
Why Firms Exist?
Counter-arguments:




Specialization does not necessarily lead to
chaos
The price mechanism has already acted as
an integrating force
Decisions made by the entrepreneur may
not be superior to consumer decisions
reached through the price mechanism
Specialization and coordination could be
realized even without firms
CH10-Nature of Firms
By Mr. LAU san-fat
12
Why Firms Exist?
Argument 2: Risk and uncertainty

With uncertainty, the entrepreneur
becomes a professional in advising
production decision and so is entitled to
having power of directing others' work.
Other input owners are willing to be
directed as they are guaranteed a proxy
payment, regardless of the market
conditions.
CH10-Nature of Firms
By Mr. LAU san-fat
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Why Firms Exist?
Counter-arguments:


People with better knowledge or judgment
may get their rewards not by actively
bearing risk of production, but by making
contracts with people who are engaged in
production.
It is possible to give a guaranteed reward
to a worker provided that certain acts
stipulated in the contract are performed
without any implication of direction.
CH10-Nature of Firms
By Mr. LAU san-fat
14
Why Firms Exist?
Counter-arguments:

The employer-employee relationship may
not guarantee the existence of firms as it is
never clear whether it is the entrepreneur
who employs the workers or the workers
who employ the entrepreneur.
CH10-Nature of Firms
By Mr. LAU san-fat
15
Why Firms Exist?
Argument 3: Solving the shirking
problem


It is costly to measure individual
contributions of team production and so it
is costly to detect whether a given team
member is shirking or by how much.
Therefore, there is a need to hire an
outsider to monitor the productive activity
of all team members and check their
performance.
CH10-Nature of Firms
By Mr. LAU san-fat
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Why Firms Exist?
Counter-arguments:


The monitor himself is subject to the
temptation to shirk. (The problem can be
solved by making the monitor as the
residual claimant)
Prof Cheung argues that the shirking
problems will vary only in degree and in
kind, depending on the form of contract
chosen or how the property or service
transacted is measured and priced.
CH10-Nature of Firms
By Mr. LAU san-fat
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Why Firms Exist?
Counter-arguments:


If individual contributions to a finished
product are priced accurately in the market
or within a firm, that person would be less
inclined to shirk. If so, why should
productive activities be coordinated by
firms instead of price mechanism.
The emergence of firms is not for solving
shirking, however, it is due to the presence
of transaction cost that causes shirking.
CH10-Nature of Firms
By Mr. LAU san-fat
18
Why Firms Exist?
Argument 4: Avoiding sales tax


A sales tax is a turnover tax imposed on
market transactions and not on the same
transactions organized within a firm.
Such a regulation would bring firms into
existence to evade taxes which would
other not exist.
CH10-Nature of Firms
By Mr. LAU san-fat
19
Why Firms Exist?
Counter-arguments:


R. Coase argues that a sales tax would
merely tend to make firms bigger than
they would otherwise be.
If so, this argument assumes the prior
existence of firms which then combine to
evade tax.
CH10-Nature of Firms
By Mr. LAU san-fat
20
The Firm Supersedes the Market?
R. Coase argues that firms exist
because of transaction costs or the
‘cost of using the price mechanism’,
including the cost of ‘discovering what
the relevant prices are’.
Also including costs:
to discover the other party to deal with,
 to negotiate the terms of exchange,
 to draw up the contract,
 to enforce the contract
CH10-Nature of Firms
By Mr. LAU san-fat

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The Firm Supersedes the Market?
Without firms, each transaction would
involve very high transaction costs in
combining many resources through
multilateral contracts among all the
individual concerned.
CH10-Nature of Firms
By Mr. LAU san-fat
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The Firm Supersedes the Market?
If these costs are substantial, a factor
owner may choose to render his right to
use his factor services to a firm in
exchange for a proxy payment, which is
not an exact measurement of his
contributions or marginal revenue
product.
CH10-Nature of Firms
By Mr. LAU san-fat
23
The Firm Supersedes the Market?
With firms, the market transactions
between consumers and input owners
that were originally guided by the price
mechanism are replaced by firm
transactions as a chain of internal
production activities by observing the
directions given by the entrepreneur.
CH10-Nature of Firms
By Mr. LAU san-fat
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The Firm Supersedes the Market?
With firms, the factor market is
separated from the product market.
However, without transaction costs, the
two markets are inseparable as firms
would not exist, a payment made by a
customer to the input owner would be
the same as a payment made to a
product seller.
CH10-Nature of Firms
By Mr. LAU san-fat
25
The Firm Supersedes the Market?
Product Market
Factor Market
Cloth-seller
A buyer of shirt
Designer
Firm
Cutter
Sewer
CH10-Nature of Firms
By Mr. LAU san-fat
26
The Firm Supersedes the Market?
By forming a firm and allowing authority
or an entrepreneur to direct the
resources in making transactions for
saving certain transaction costs,
according to Coase, a firm supersedes
the market or a factor market
supersedes a product market.
CH10-Nature of Firms
By Mr. LAU san-fat
27
Cheung’s Elaboration
On top of Coase’s argument, Prof
Cheung elaborates why it is costly to
use the price mechanism without a firm:
First, there is huge contracting costs as
the number of transactions are very
large.
CH10-Nature of Firms
By Mr. LAU san-fat
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Cheung’s Elaboration
Cloth-seller
Designer
A buyer of shirt
Cutter
Sewer
Without firms, the no. of transaction is
large:

1 buyer only: 8 (4 FT + 4 PT)
3 buyers: 24 (12 FT + 12 PT)

CH10-Nature of Firms
By Mr. LAU san-fat
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Cheung’s Elaboration
Cloth-seller
A buyer of shirt
Designer
Firm
Cutter
Sewer
With firms, the no. of transactions is greatly
reduced:

1 buyer only: 5 (4 FT + 1 PT)
3 buyers: 7 (4 FT + 3 PT)

CH10-Nature of Firms
By Mr. LAU san-fat
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Cheung’s Elaboration
Second, without firms, the information
cost in knowing each and every part of
a product tends to be significantly high.
With firms, the entrepreneur acts as a
specialist agent in contracting with the
input owners at lower transaction costs.
Consumers thus bear less cost in
knowing the whole product instead of
recognizing the value of each
component part.
CH10-Nature of Firms
By Mr. LAU san-fat
31
Cheung’s Elaboration
Third, the measurement cost will be
prohibitively high in a transaction if the
attributes of the product are
complicated, if the production activities
change frequently or vary extensively.
To be more economical, a proxy will be
used by a firm to replace direct
measurement of these activities.
CH10-Nature of Firms
By Mr. LAU san-fat
32
Cheung’s Elaboration
Four, the contribution of each input
owner may not be easily delineated in
doing collaborative or team work and
thus some may claim more than is
deserved.
With firms, the entrepreneur pays each
input owner a price by a proxy on a
take-it-or-leave-it basis instead of
measuring exact contribution.
CH10-Nature of Firms
By Mr. LAU san-fat
33
Do We Need a Mega Firm?
As argued by Cheung, firms exist to
reduce the transaction costs in using
the price mechanism, should we build a
mega firm to organize all production
activities?
CH10-Nature of Firms
By Mr. LAU san-fat
34
Do We Need a Mega Firm?
Coase observes that when the firm
expands the entrepreneur becomes less
efficient and its extra costs of
organizing extra transactions increase.
Thus, the firm will expand until at the
margin, the costs of organizing within
the firm will be equal either to the cost
of organizing in another firm or to the
costs involved employing the price
mechanism.
CH10-Nature of Firms
By Mr. LAU san-fat
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The Nature of the Firm
Consider the case that a worker joins a
factory/firm and is paid exactly
according to the output he or she
produces (using the price mechanism).
Is the production organized by the firm
or through the price mechanism?
CH10-Nature of Firms
By Mr. LAU san-fat
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The Nature of the Firm
Cheung argues that instead of saying
the firm supersedes the market, or the
factor market supersedes the product
market, it is more accurate to say that
one type of contract supersedes or
replace another type.
CH10-Nature of Firms
By Mr. LAU san-fat
37
The Nature of the Firm
Firms would choose among different
types of contracts and adopt the one
with least transaction costs, thus the
choice of organizational arrangements is
actually a choice of contractual
arrangements.
CH10-Nature of Firms
By Mr. LAU san-fat
38
The Nature of the Firm
Cheung further argues that it is futile to
determine what a firm is or what
optimal size a firm should be as it is
often impossible to draw a clear
dividing line separating one
organization from another when
multilateral contracts are allowed
among many different market
participants.
CH10-Nature of Firms
By Mr. LAU san-fat
39
Contractual Arrangements
Firms would choose among different
types of contracts and adopt the one
with least transaction costs, thus the
choice of organizational arrangements is
actually a choice of contractual
arrangements.
The choice of contractual arrangement
could be explained with the
assumptions of non-zero transaction
costs and risk aversion.
CH10-Nature of Firms
By Mr. LAU san-fat
40
Wage/Time Rate Contract
Time rate contract is suitable if the
quality of product is important
It is not suitable for the worker is his or
her product cannot be easily
standardized or measured.
CH10-Nature of Firms
By Mr. LAU san-fat
41
Wage/Time Rate Contract
Advantage:

The pricing and measuring costs could be
saved as the worker is paid by a proxy
rather than the exact amount he or she
produces.
Disadvantages:


The worker tends to shirk or to reduce his
or her working intensity or output quantity.
Higher monitoring costs involved
CH10-Nature of Firms
By Mr. LAU san-fat
42
Piece Rate Contract
Piece rate contract is preferred if the
component of a product can be easily
standardized or measured, or when the
task performed by the work is repetitive
and does not vary frequently.
It will be adopted if the cost of
measuring the contributions by each
individual is not significant.
CH10-Nature of Firms
By Mr. LAU san-fat
43
Piece Rate Contract
Advantages:


The quantity shirking problem could
possibly be avoided
Monitoring cost could then be saved
Disadvantage:

The worker tends to rush and neglect the
product quality, resulting in quality shirking
problem
CH10-Nature of Firms
By Mr. LAU san-fat
44
Rental or Fixed Rent Contract
Advantage:

The shirking problem could be eliminated
as the worker will work harder for
maximizing the residual incomes after
paying fixed rents for the use of other
inputs.
Disadvantages:


Monitoring costs involved in examining the
inputs provided by other input owners
The depreciation rate and maintenance
cost will be higher
CH10-Nature of Firms
By Mr. LAU san-fat
45
Share Contract
Share contract refers to the contractual
arrangement that an agreed proportion
on output is shared between the parties
involved.
Advantage:

Production risk could be shared
Disadvantages:

The pricing and measuring costs, and the
monitoring costs involved are higher than
that of other contractual arrangements.
CH10-Nature of Firms
By Mr. LAU san-fat
46
Gratuities or Tips
Advantages:
Providing the employees with an incentive
to perform well
 The employer has less to lose if the worker
does poorly, i.e. risk could be shared
 Information costs could be saved in
assessing the worker’s performance by
checking with amount of the tips one earns.
 Monitoring costs could be saved as the
customer would monitor the worker for the
employers
CH10-Nature of Firms
By Mr. LAU san-fat
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
Outright Sale or Purchase
Suitable for non-human resources
If the monitoring costs involved in using
the asset are high or the assets
depreciate quickly or policing and
enforcing its maintenance are costly,
the owner may prefer outright sale to
rental contract.
CH10-Nature of Firms
By Mr. LAU san-fat
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