ECON 4245 – ECONOMICS OF THE FIRM
Overview of the course
Basic questions:
• Why do firms exist?
Why do firms
• buy other firms?
• merge?
• go bankrupt?
• How are firms financed?
• How are firms managed?
Basic analytical tools:
• Microeconomics, in particular:
• Economics of information
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 1
The economics of information – the big picture
Three information problems:
• Hidden information – adverse selection
Financing the firm
• [Hidden actions – moral hazard]
Managing the firm
• Unverifiable information – incomplete contracts
Theory of the firm
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 2
Theory of the firm
Reading:
Oliver Hart, Firms, Contracts, and Financial Structure,
chs. 1-4.
[A broader picture:
ECON 4920 – Economic Systems, Institutions and Globalization]
Question:
Why do firms exist?
Refined question:
Why are some transactions carried out within a firm and
others in the market?
• outsourcing
• make or buy
• takeovers
Another interesting question:
What do firms do?
Do they maximize profits?
- hidden action
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 3
Why do firms exist?
Traditional economic theory: Technological explanation.
Firms are big because of economies of scale.
Firm size determined, in the long run, by the shape of
C(q)/q.
C’(q)
q*
C(q)/q
q
• Why is the curve U-shaped?
• Managerial problems in big firms?
• Plant/Division vs Firm
- One big firm, many divisions each of size q*
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 4
Agency theory
Incentives problems within the firm
q = g(e, ε)
q – observed output
e – manager’s effort
ε – random variable
Owner cannot know whether high q is due to high effort or
shear luck.
Trade-off: Incentives vs. risk sharing
P(q) – payment to manager as a function of the observed q
P’(q) high: incentives high but manager takes on too much
risk
P’(q) low: risk sharing more appropriate but incentives low
The same problem occurs both within the firm and between
firms.
The agency theory cannot easily be applied to our question,
Why are some transactions carried out within a firm and
others in the market?
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 5
Transaction-costs theory
Ronald Coase - Nobel laureate 1991.
”The Nature of the Firm” (1937).
Inside or outside the firm?
• Outsourcing; Make or buy
Some market transactions are costly, and it may therefore
be cheaper to make the item oneself rather than buy it.
• Market transactions are governed by contracts
But:
• Contracts are incomplete
- unforeseen contingencies
- difficult to agree on terms
- costly to write contracts
… leading to:
the property-rights approach
• The contract is used to determine ownership – the right
to decide over the assets involved.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 6
Examples of contract incompleteness
• Unforeseen contingencies: A in Paris is supposed to
deliver equipment to B in Oslo. But no-one has
anticipated a strike among air-traffic controllers.
• Other possible unforeseen contingencies:
- an unanticipated change in demand
for B’s products
- a change in regulations of A’s and/or
B’s businesses
- innovations that may, for example,
make A’s products obsolete as input
in B’s production.
• Simplicity: The contract specifies that A sends one item
in each delivery, even though B’s requirements varies
with wear and tear of her existing equipment, because it
is too complicated to specify exactly under which
conditions more than one item is needed, or those
conditions are unknown.
• Limitations: The contract is limited to one year, because
it is difficult for B to see what her demands will be after
that, and it is difficult for A to see what his abilities to
deliver will be.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 7
The consequence of incomplete contracts
Revisions and renegotiations.
• Find a new delivery time given the strike and how
the costs of the delay are to be distributed between
A and B.
• Order more items when the contracted delivery is
too small and agree on the price of the extra items
• Extend the duration of the contract and agree on
terms for the next period
Question: Can the law fill in gaps in contracts?
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 8
Problems with renegotiations
• Negotiations over revisions take time and resources
• At the stage of renegotiation, the two parties may be
asymmetrically informed
• B has received information, since the initial contract
was written, about the demand for its products. This
information is not known to A.
This makes it difficult to agree on a revised contract.
These are ex-post costs of renegotiation.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 9
But why bother to renegotiate?
• Renegotiation would not be necessary if the parties
could costlessly switch to new trading partners.
The contract parties cannot switch without costs if they
have made ex-ante relationship-specific investments.
• B may have made investments in machinery that is
customized to the equipment delivered by A
• A may have made investments in knowledge about
the production process that is specific to the
requirements of B.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 10
The ex-ante costs of renegotiation:
If such investments in the relationship cause problems for
you later on, when revision of the contract is necessary, you
may want to invest less than what is socially optimum.
• Because of the risk of renegotiation later on, A and
B use machinery and knowledge that are more
general-purpose than what would be profitable for
them if a complete contract could be written.
• If B’s machinery can only be used together with
equipment from A, then B’s bargaining position
during renegotiations is weak. B does not want this
to happen.
This is called the hold-up problem.
Summary so far:
• incomplete contracts
• relationship-specific contracts
→ the hold-up problem
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 11
To integrate or not to integrate – that is the question
Should A and B continue as two separate firms, or should
they integrate into one firm?
If they continue as separate firms:
• the hold-up problem
• transaction costs
The alternative: Integration
But:Who is the owner of the integrated firm?
What does it mean to be owner?
Authority: The right to make decisions when something
occurs that is not written into the contract.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 12
The property-rights approach:
A and B have three options:
• continue separately
• integrate with A the owner
• integrate with B the owner
For example: B being owner of the firm A+B is
• good for B, and
• bad for A,
relative to non-integration.
• A looses the right to renegotiate.
When the initial contract is written, they make the
integration decision. The arrangement that maximizes their
combined expected profits is chosen.
• The transaction-cost theory emphasizes the costs of nonintegration.
• The property-rights approach emphasizes that there are
also costs of integration [for the non-owner(s)].
Integration occurs when its benefits exceed its costs,
relative to non-integration.
Economics of the firm – Tore Nilssen – Lecture 1: Theory of the firm – page 13