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Lecture 1 Theory of the Firm
Theory of the Firm (University of Liverpool)
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LECTURE 1: ECON254 THEORY OF THE FIRM
INTRODUCTION AND THE NATURE OF THE FIRM IN A MARKET SYSTEM
[8]
Outline
The purpose of this lecture is to:
-
define theory of the firm
define economics and examine the implications of scarcity
explore the role of prices and profits in a market economy
explore the nature and importance of firms in the market system
explore the nature and importance of internal structure
[9]
What is theory of the firm?
Theory of the firm broadly relates to an umbrella of economic theories that
describe, explain, and predict the nature of the firm (be it a company,
corporation or organization), including its existence, behaviour, structure, and
relationship to the market.
We are interested in the decision making of firms based on the business
environment they are subject to and in turn how this feeds into the business
environment that they are in.
For example a framework you may be familiar with for describing the business
environment is the PEST or PESTEL framework. Where each letter represents
an area of the business environment. Political – Economic – Social –
Technological – Environmental – Legal. Each firm will be affected differently by
each of these and it is common for businesses to undertake a PESTEL or other
framework analysis to consider the factors most impacting their business
decision making.
But for many decisions we can model the internal decision making process (the
micro-economic environment) which will comprise a large part of the course
using first founding neo-classical economic theory which is then expanded
through business economic theory and managerial theory.
___
Microeconomics environment is the small workings in a market.
[10]
What do Economists study?
Richard Lipsey defines Economics as:
1. The allocation of a society’s resources among alternative uses and the
distribution of the society’s output among individuals and groups.
2. The ways in which production and distribution change over time.
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3. The efficiences and inefficiences of economic systems
What he is essentially saying is that economics deals with the notions of:
 What to produce
 How to produce it and
 For whom?
Opportunity costs: Opportunity costs represent the benefits an individual,
investor or business misses out on when choosing one alternative over
another.
[11]
Economics deals with the fundamental problem with which every society must
grapple and that is how society can make the best use of its resources. That is,
the underlying fundamental problem of economics is the problem of scarcity:
choices have to be made about how best to use the finite resources available.
Scarce or ‘finite’ resources:
Factors of production:
- Land
- Labour
- Entrepreneurship
- Capital
These are combined to produce goods and services.
Consumers then choose the goods by carefully considering their opportunity costs
(consumer choice  spurs production). We will see later that this then sends
market signals via the market or price mechanism to the producer which spurs
further production of only the goods that have the higher value. This ensures the
goods produced are making the best use of resources, i.e. resources are allocated
to the production of their highest value use thus there is ‘allocative efficiency’.
Thus this fundamental problem of scarcity confronts firms AND individual
consumers. In order to understand these we study both firms and consumers
behaviour. Both individuals (consumers) and firms (producers) are assumed to be
rational in their decision making – in that they attempt to maximise their net
benefits.
[12]
The crux of scarcity is that individuals, firms and society have to make difficult
trade-offs. This is reflected in the fundamental concept of opportunity cost which
is defined as “the value of the best alternative foregone” when taking any
particular course of action.
What do we mean by ‘rational’ behaviour. Well we mean maximizing behaviour,
trying to get the best out of any choice. Because of opportunity cost, both
consumers and producers weigh up the marginal costs (MC) of decisions against
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possible marginal benefits (MB). ‘Marginal’ analysis considers the next unit of
production or consumption. For firms MB is additional revenue earned from the
next unit, for consumers MB is the amount of satisfaction they receive (this is
measured in ‘utils’ or utility which can handily be measured in units of currency.
If MC is greater than MB, then there is not a net benefit so they will not consume
or produce the next unit. If MB is greater than MC there will be a net benefit and
they will consume or produce the next unit and go on to consider the next unit after
that. Consumption / production settles at the optimum point where MC = MB.
Here all of the gains have been exhausted.
Marginal decision making is thinking about the next unit, so if the benefits of next
unit outweighs costs, then we gonna buy/do it. Otherwise NOT.
[13]
The price mechanism and the role of the market
Markets are where buyers (demand) and sellers (supply) meet to trade.
What the price mechanism does is guide the allocation of resources. If prices
rise due to high demand, then it pays firms to produce more. The higher price
allows them to bid resources away from alternative uses. As prices rise, this will
also choke off demand as more utility is required from the good to justify
purchasing at the higher opportunity costs of higher prices.
As we will see, effective demand is the demand of consumers who are willing
and able to pay. ‘Effective demand’ is influenced by several factors that influence
the group of individuals: Incomes, tastes (preferences), price of related goods,
expectations in the market, but also importantly ‘spill-overs’ from other markets
such as availability of credit in credit markets or even externalities from other
markets.
Price is the outcome of the interaction between supply and demand, for any
given level of supply, the demand will determine the price. However, if prices
systematically rise (inflation) or fall (deflation) across markets, this can distort the
market mechanism as it is the relative prices that are important (and can lead to
an information cost).
How much profit is made is then determined by the costs of production of any
particular supply amount which are influenced by the market environment. The
consideration of this determines the actual supply decision.
Therefore high prices and high profits indicate strong demand relative to supply
and both are a signal and incentive for firms to increase supply. Market
success is rewarded by greater control over resources.
The market mechanism is thus depicted as one way, demand of consumers
informing producers.
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[14]
Strategic choice in markets
Profit is the difference between revenues and costs (later on we will write this
short-hand as π = TR - TC) and this deceptively simple fact implies two major
strategic considerations facing all firms:
1.
2.
Revenue enhancement
Cost control
How they enact those strategic choices in the short and long term leads to the
very nature of firm’s existence.
A lot of what we will do in this course is related to this ‘simple’ concept of profit
maximisation!
[15]
The Nature of the Firm (see Begg&Ward ch. 7.4)
In 1937 Nobel Prize winning economist Ronald Coase posed and answered the
question: Why do firms exist?
In what has become one of the most widely quoted phrases in economics Coase
(1937 p388) asserted: “It can, I think, be assumed that the distinguishing mark of
the firm is the supersession of the price mechanism”
 A firm exists if it can something cheaper than the concurrention.
“A firm… [has] a role to play in the economic system if… transactions [can] be
organized within the firm at less costs than if the same transactions were carried
out through the market. The limit to the size of the firm… [is reached] when the
costs of organizing traditional transactions within the firm [exceed] the costs of
carrying out the same transactions through the market.” Coase (1952 p341)
Essentially it points to the fact that there are two basic methods of
coordinating the production and distribution of goods and services in a
market economy:


the firm or
the market.
e.g. If I make engines that require a particular part we will call a ‘widget’, do I
make that myself by buying the raw materials and manufacturing it, or do I buy it
from a producer that makes widgets?
The basic claim of transaction cost economics is that the boundaries of the
firm will be determined by the principle that the firm will internalise a transaction
when the costs of conscious coordination of resources within the firm are less
than the transaction costs of using the market.
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‘Transaction Costs’ meaning any costs of your transactions, i.e. costs of dealing
in the market – things such as:
• Costs of discovering the relevant price (best price?)
• Costs of negotiating and enforcing contracts
• Costs due to uncertainty and risk.
If transaction costs are high  worthwile to form a firm. There is a gap in the
market.
Essentially the scope of the firm will reflect the outcome of a series of ‘make-orbuy’ decisions. Although, obviously this is further complicated by the reality of
decision making, in short - any factors which causes markets to behave poorly
will encourage the increased scope of the firm and vice versa.
[16]
Two fundamental problems which can cause markets (and indeed firms) to
work poorly are:
1.
2.
Bounded rationality:
 Consideration of MC versus MB is dependent on: information;
time available to decide; level of cognition
Asymmetric information:
 When one party in a transaction has more information than the
other.
 Information asymmetry - also referred to information
impactedness - when the buyer and the seller have knowledge
of different private information when they take part in complex
contracting (Oliver Williamson, 1985, p51). This condition is
costly to overcome and gives rise to a trading hazard,
occasionally resulting in market failure (George Akerlof, 1970,
cited by Williamson, 1985, p212).
Information asymmetry exists when:
a) Uncertainty/complexity
b) One person has more information than another and uses it to gain
advantage. This opens up what Oliver Williamson (1975, p26) called
the possibility of opportunism, which he further defined as selfinterest seeking with guile.
c) Small number of exchange relationships - The problem of opportunism
is at its most acute when a firm has very limited or no alternative
sources of supply.
[17]
Information asymmetry gives rise to problems of:
a) Adverse Selection
 A worst or ‘adverse’ outcome is selected due to inability to
distinguish between good and bad products or agents.
 E.g. If you cannot distinguish between smokers & non-smokers,
insurance premiums may be based on the average cost, but this
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means the premiums will be higher than the costs incurred by nonsmokers, thus driving them out of the market leaving only smokers!
b) Moral Hazard
 a situation where a party is more likely to take risks because the
costs that could result will not be borne by the party taking the risk
 e.g. if you have insurance for your iPhone, you may take less
precautions from losing/damaging it.
c) Hold-up problem
 Where the most efficient outcome of two parties cooperating, is
limited or deterred due to concerns that each may give the other
increased bargaining power, and thereby reduce their own profits.
 E.g. When party A has made a prior commitment to a relationship
with party B, the latter can ‘hold up’ the former for the value of that
commitment.
 As well as leading to additional costs the hold-up problem might
also lead to underinvestment (people choosing not to contract).
 Construction company says the building time will be 6 months,
they’ll start and finally the building duration is 8 months.
[18]
These are fundamental facts of economic life which affect relationships between
firms, within firms and between firms and consumers. They imply the importance
of adapting with respect to:
1.
2.
3.
Devices for revealing or better using information;
Learning by firms and individuals over time through the acts of
production and consumption in markets;
The ability to adapt to unforeseen events
Many issues can be addressed with the formation of market contracts, but such
contracts create transactions costs.
[19]
There are several transaction costs (costs of using the market) which can
be avoided, at least to some extent, by establishing or expanding the scope
of a firm:



Search costs of finding someone to contract with.
Here there is often a hidden information problem where one
person cannot assess the ability of another.
Costs of writing contracts.
A very important concept is that contracts may be incomplete either
because it is impossible or simply too expensive to write a clause
into the contract covering every possible contingency. This opens
up the possibility of opportunism, which is more acute where very
limited or no alternative sources of supply (happens i.e. when there
is asymmetric information.
Costs of monitoring contracts.
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
In this case there can be what is called a hidden actions problem
in that one party may not be able to observe very well what the
other is doing.
Costs of enforcing contracts
Such as Legal costs; nuisance value; or the ‘hold-up’ problem
(described earlier), whereby even a successful legal action can’t
bring back the ‘time’ wasted.
[20]
Markets may fail for reasons other than the existence of opportunism. These
types of market failure are generally termed co-ordination failures. Firms have
a number of advantages over markets for dealing with some of these problems:
1. The complexity of contracting is lessened as the firm swaps a more
general employment contract for a more specific contract to supply
with another firm.
2. The firm also has available much wider monitoring and discipline
powers compared to market exchange.
There are three constraints on the extent to which the firm may supplant market
exchange:
1.
2.
3.
As the size and scope of the firm increases, the bureaucratic
costs of administration my rise disproportionately. The costs of
coordinating resources within the firm are known as
management or governance costs.
Linked to this is the fact that there is a limit to the amount of
things one firm can do well.
Markets provide more high-powered incentives than firms to be
efficient.

[21]
Questions
[22]
Quiz
Does industry structure relate to the way firms behave and the kind of profits they
can make? Think about what a typical firm is like that produces instant coffee,
versus a typical ‘firm’ that produces locally grown carrots?
[23]
The structure of Markets and Industry
The structure-conduct-performance paradigm tells us that the structure of the
market is important in determining firm’s behaviour (is the market competitive or
not? On price, or perhaps branding?) and thus performance (what level of profits
does it make? How much market share? How much growth? etc.)
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These structures can be differences in internal firm structures or organisation as
well as market structures. We will consider this in depth throughout the course but
particularly in lecture 5.
We will look at 4 flag-pole market environments ranging from the most
competitive (perfect competition) to the least competitive (monopoly) and that those
market environments have implications for the revenue and cost structures of firms
(lecture 4).
We also have to consider industry structure and indeed most governments collate
statistics on industries strata.
Most governments take statistics on each sector of their economy, which all coordinate against international standard classifications – so we can compare
countries reasonably easily. The UK uses Standard Industrial Classification or
‘SIC’ codes to divide firms economic activity into sections, subsections, divisions,
groups and classes.
Additional note for readers: If you were to register a new company in the UK with
Companies House (which you must do legally to register for tax purposes if you are
anything other than a ‘sole trader’) you must provide this classification if your
business accordingly [See for yourself:
http://www.companieshouse.gov.uk/infoAndGuide/sic/sic2007.shtml ]
The UK has kept this information since 1844, including regular updates of the SIC
codes to cover new and expanding industry (for example in 2011 the Government
created sub classifications in different groups to denote ‘creative industries’). We
can therefore see changes over time.
[24]
Historical Changes
The structure of industry and markets is not static.
Industry structure:
As economies develop they tend to move away from Primary (Agriculture/Mining)
and Secondary production (Manufacturing) towards Tertiary production
(Services).

In the last century, there has been a substantial shift from the primary and
secondary sectors to the tertiary sector in industrialised countries
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(“tertiarisation”). The tertiary sector is now the largest sector of the economy
in the Western world, and is also the fastest-growing sector.
Additional note for readers: The simplest is the classification of industry,
where we can think of a kind of pyramid:
 Primary production is concerned with raw natural resources, i.e.
Agriculture and the extraction of those natural resources.
 Secondary production is concerned with manufacturing & Construction.
Such manufacturing and construction can be both creation of capital (i.e.
machinery to make more goods) or products.
 Tertiary production is essentially the production of Services or intangible
goods (instead of physical end products), this can be any services, which
include transporting goods, pest control, entertainment or banking.
Traditionally this has even included information services (though some
economists like to separate information as a 4th, or quaternary sector!)
Many economists argue the ‘quaternary’ sector (Knowledge based/ Intellectual
Property) is becoming more important.
Sectors may tend towards different market structures.
Sectors like Mining and Quarrying (B); Electricity, gas etc. (D) and Water supply &
sewage etc. (E) turnover tends to be dominated by large companies, whereas
turnover in agriculture, forestry and fishing tends (A) to be dominated by SMEs.
We might want to think about the impact of scale (Lecture 3!).
Market Structure:
Increasing Globalisation of businesses - particularly manufacturing. We will
consider this in lecture 11.
[25]
The determinants of business performance
There is a relationship between firm and industry structure and performance. We
will look into this in detail in lecture 5.
Internal aims and organisation
• Is Profit maximisation the prime goal? We assume it is but there are other
goals of some organizations.
• Is there a Distinction between owners and managers? Some companies are
‘sole proprietors’ and there is no distinction, while in others there could be
layers of management between owners and the actual running of the
company.
• This means that managers’ own objectives are also important!
• There exists the potential to have discrepancies between risk taking
behaviour from owners and managers and a possibility of
‘satisficing’.
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•
•
Or more essentially the Principal-agent problem where any time a
principal employs an agent, they can never be sure that agent is
following the principal’s interests or their own!
Internal structure of the firm (we will discuss this further in the next section)
Other factors affecting performance
• Information (and dealing with imperfect information). We have already talked
about this. But also systems – this relates to all of the systems that the firm
can put in place:
• information systems; motivation; technical systems; distribution
systems; financial systems
• People – a business can thrive or dive on the competence of management
and the quality of the workforce
[26]
INTERNAL STRUCTURE
The importance of the organisation of businesses:
A firm structure must organize Complex production:
• production through markets
• production through firm hierarchy
The essential aim of organising production  is to reduce transactions costs
Internal structure refers to the relationships between different parts of the
organisation (and also what different parts to break the organisation down into).
In a landmark study Alfred Chandler (1962, 1977) examined how innovations in
organisational structure allowed firms to grow by offsetting the inefficiencies which
can arise as firms, become larger and/or more complex. This is the crux of the
structure follows strategy thesis.
Products has become more complex, the more complexity in production process,
more thinking about reducing transaction costs.  Structure followers strategy.
[27]
Unitary Structure (U-form)
In the functional or unitary structure, the U-form, the organisation is managed as
one big entity with a hierarchy based on specialist functions such as purchasing,
production, marketing etc. ultimately responsible to a peak coordinator or chief
executive.
[28]
The advantages of the U-form:
 Specialisation and exploitation of the division of labour.
 When there is strong interdependence of divisions they are better managed
as a whole
 Allows sequencing of flows of products down a vertical chain
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
The delegation of authority should leave the chief executive free to
concentrate on strategic issues.
o Chief executive also able to implement strategy across divisions
[29]
Unfortunately, however, it suffers from a number of disadvantages or problems:
1. Each department deals only with its own given agenda
 Lack of flexibility
 Lack of accountability
 Profitability cannot be observed
2. Decisions are outcomes of negotiations across the divisions.
 May even be development of functional factions
 Different Interests of owners, managers and divisions
3. Peak coordinator can quickly become overloaded with information.
4. Control loss is compounded as the number of hierarchical levels increases.
 This will be the case if the span of control is relatively fixed.
5. Inhibits growth
 Centralisation is not well suited to coping with a range of different
products or markets.
 problems when firms expand beyond a certain size
i. bounded rationality
ii. communications costs
iii. distorted information
iv. decline in organisational efficiency
Point (1) may be associated with an inherent tendency for financial resources to be
misallocated in U-form firms.
[30]
The Nature and Economics of the M-Form.
The distinguishing marks of the M-form are the splitting of the company into semiautonomous profit-responsible divisions, which are coordinated at the strategic
level by a head office. The principle is to put together in divisions all those activities
which interact strongly and to put in separate divisions activities which interact only
weakly.
H e a d O ffic e
D iv is io n 1
P r o d u c tio n
F in a n c e
D iv is io n 2
S a le s
D iv is io n 3
P u r c h a s in g
[31]
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Advantages:
The M-form provides solutions to the problems of:
- Control loss, information overload [Although we can never solve ALL
information problems], complexity and inflexibility as firms grow and
diversify.
- It also economises on information as information does not have to
funnel down a long vertical column of hierarchical strata from the peak
controller. This works the other way, with information more easily collated
and returned by divisions to the peak controller.
- Within each division the U-form can be used, therefore its strengths are
not lost. The head office can then free itself from operational concerns
and concentrate on strategic thinking. Because they are able to compare
the divisions, any successful innovations in one division can then be
adopted in others.
- Head office can then free itself from operational concerns and
concentrate on strategic thinking.
Williamson has described the multi-divisional structure (M-form) as the most
significant organisational innovation of the twentieth century arguing that large
organizations would need to take on a divisionalized structure as the scale of the
business expanded.
[32]
The M-form Hypothesis.
Williamson also argues that because of its advantages the M-form firm should
come closer to profit maximising behaviour than other organisation forms and
thus should exhibit superior performance. This is known as the M-form hypothesis.
The benefits of the M-form are assumed to spill over more widely in the economy
(efficiency  lower costs, technological improvement  more, higher quality
goods).
Moreover because of its superior performance, it is likely to become the dominant
form of internal structure. This was born out in the 2nd half of the 20th Century,
starting in the 1950’s & 60’s and by the early 70’s became the dominant form.
Comparison of the U-form and the M-form reveals that structure matters crucially
because it affects:
1. the flow of information within an organisation;
2. the ability to monitor performance and provide incentives;
3. the amount of decentralisation which can be achieved.
The M-form as a Mini Capital Market
In the M-form, in theory at least, profits belong to the whole company and head
office plays a crucial role in deciding how those profits should be allocated between
the divisions.
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Internal management is also seen as having much greater powers of audit than
do external shareholders and can intervene more readily to tackle deviations from
agreed actions.
The ability to compare divisions is seen as an important advantage of the M-form
firm over the U-form firm. What is more, it is easier in some respects to incentivise
managers within a divisional structure than in a U-form firm. Divisions can then be
given greater freedom to respond as they see fit to developments in their markets.
Therefore the M-form Hypothesis also considers that corporate managers must
strike a careful balance in an M-form.
- They must encourage competition between divisions for capital and
recognition.
- They must encourage cooperation in those areas where synergies
exist between divisions in order to obtain higher overall levels of
performance,
M-forms that are able to strike this balance will outperform both large U-forms and
all H-forms.
[33]
Disadvantages of M-Form
Although Williamson’s M-Form hypothesis is compelling, there are still some
drawbacks to the M-Form structure including:



Power Balance
o Centralizing decision making reduces costs and reduces risk of
division managers jeopardizing goals of the firm by their risk-taking
actions or pursuing their own sub-goals. But takes away from the
strengths of M-Form in allowing strong division managers flexibility to
innovate.
o Between Central Interference / Strengths of Divisional Managers
Cost of management hierarchy
o Adding layers of hierarchy adds costs in terms of management hours,
but also in transition up the hierarchy.
Competition between divisions
o This can occur for the resources of production (i.e. suppliers) or for
internal resources of the firm. This is a waste of resources for the firm
as a whole.
[34]
Non-Hierarchical Internal organisation of the firm
Organisation can be hierarchical or non-hierarchical, though non-hierarchical
forms are relatively rare, although gaining in popularity among new enterprises.
They tend to be limited to Peer Groups & Co-operatives, although some private
sector, e.g. computer programming based industries have adopted these.
Reasons for may be:
• Colaboration of Specialist roles
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•
•
•
May have indivisibilities across roles
Shared Risk
Other Reasons e.g. Political ethos
Benefits:
• Increase motivation (everyone a stakeholder)
• Concensus means everyone will agree to decisions together (not imposed
top-down) which can increase motivation towards or reduce resistance
against decisions.
Drawbacks:
• Collaborative decision
Communication
making
is
time
costly
and
requires
good
Are they likely to increase in future? Read this
http://www.theguardian.com/voluntary-sector-network/2012/jul/02/charities-nonhierarchical-structures
[35]
Other internal organisations of the firm
The flat organisation
A relatively new phenomenon is the ‘flat organisation’ where information technology
allows senior management to communicate directly with workforce.
Multinationals and business organisation
- Integrated international enterprises
One in which an international company pursues a single business
strategy. It co-ordinates the business activities of its subsidiaries across
different countries.
- Transnational associations
A parent company binds subsidiary companies by contract to provide
output or receive inputs from other subsidiaries.
[36]
The H-Form (or ‘Holding company form)
The H-Form is a business which holds multiple subsidiary companies across
different interests, i.e. a 'holding company' for lots of different business activities,
e.g. the Walt Disney Company (next slide) makes movies, runs theme parks and
creates consumer products.
In an H-form organization, performance of each business is assessed
individually, as difficult to compare different business types. Resources
are allocated across the holdings by central decision. However, the complexity
of holding diversified (i.e. unrelated) businesses, mean difficulties in comparing
profitability as well as allocating resources and integrating activities.
Empirical research by Michael Porter suggests that such organizations therefore
achieve only 'average-to-weak' financial performance.
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© Dr. S.L.Phythian-Adams & Dr. B. Murakozy, University of Liverpool, 2019
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References:
Lipsey, Richard & Chrystal, Alec (2011) ‘Economics’, Oxford University press,
Oxford, UK.
Akerlof, G. A. (1970) “The market for "lemons": Quality uncertainty and the
market mechanism”. The Quarterly Journal of Economics, Vol. 84 (No. 3), 488500.
Chandler, Alfred D., Jr. (1962/1998), ‘Strategy and Structure: Chapters in the
History of the American Industrial Enterprise’. Cambridge, MA: MIT Press
Chandler, Alfred D., Jr. 1977, ‘The Visible Hand’, Cambridge, Mass. and
London, England: The Belknap Press of Harvard University Press
Coase, R. H. (1937) “The nature of the firm”. Economica, 4 (16), 386-405
Williamson, Oliver E. (1985) “The economic institutions of capitalism: Firms,
markets, relational contracting”. New York: Free Press.
Williamson, Oliver E. (1975) ‘Markets and hierarchies: Analysis and antitrust
implications’, Free Press, New York.
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Lecture 1 Mini Quiz.
1.
Economics studies individuals and organisations in society
engaged in the
a)
production of goods and services
b)
distribution of goods and services
c)
consumption of goods and services
d)
all of the above
e)
none of the above
2.
There is no problem in deciding what to produce when the
economy's resources increase over time.
a) True
b) False
3.
The market system resolves the problem of what to produce by
considering the prices that individuals are willing to pay for
goods and services and the costs associated with producing
them.
a) True
b) False
4.
Why does scarcity exist?
5.
How does the concept of opportunity cost relate to the problem
of scarcity?
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