LECTURE WEEK 7 (18/10): UNIT 6: THE FIRM. OWNERS, MANAGERS AND EMPLOYEES.

1. Introduction
Outsourcing (offshoring: relocation of part of a firm’s activity outside the national
boundaries in which it operates)  Apple outsources production to countries that are not
its main market.

A firm is a business organization in which private owners:

- Employs people  hire and direct labour
- Uses (purchases) inputs (capital goods) to produces outputs (goods and services)
- Sets prices greater than the cost of production to make profit 
 Principal (classical) goal: maximize its benefit
o Other goals: growth (Amazon makes little profit because it’s focus on
growth, at least in the short run); environment, etc.
Amazon’s success may be also thanks to its focused-on replicating “internal markets”
The firm in a capitalist economy is a miniature, privately owned, centrally planned economy.

The importance of work and firms in the economy:

- Work is how people produce their livelihoods  decide how much to spend working:
trade-off between free time and the wage
- Production, wages and living standards have grown  new technologies adopted by
firms
- Voluntary contract between labour and other inputs: owners to determine how the
surplus will be shared, depending on their bargaining power.
- Division of labour coordinated through market exchange
- Sometimes people need to work together: success depends on preferences and
strategies to discourage free riding.
- Another way of coordinating and combining with other inputs  organization within
a firm.
2. Firm, markets, and division of labour
Division of labour: specialization of producers to carry out different tasks in the production
process.
In capitalist economies, the division of labor is coordinated in two ways: firms and markets.
Coordination within firms differs from coordination via markets:
A) Firms:
- Concentration of economic power in hands of owners/managers allow them to issue
commands to workers.
- Employees are coordinated and directed by their managers  decision-making
structure in which some have power over others.
- Have a decision-making process and ways of imposing their decisions on ppl in it.

B) Markets:
- Power is decentralized in markets: decisions are autonomous and voluntary.
- An order in a market is a request for a purchase that can be rejected if the seller
pleases.
- Prices that motivate and constrain people’s actions in markets are results of actions
of thousands of individuals, not by someone in authority.
If lots of owners (buying stock of Amazon), they are not going to influence decisions.
- Owners: decide long-term strategies through their board of directors  how, what,
where to produce  direct the managers to implement these decisions
- Managers: how the firm is run: they implement their decisions by assigning tasks to
workers and monitoring them

Separation of ownership and control: managers decide on the use of other people’s funds.

Importance of information arrows  asymmetric information (relevant info not known by

all)

Managers do not have complete

information about what workers are
doing

Some owners do not know what

managers are doing.

Problem: conflicts of interests: what manager does influences to the firm’s profit.
- Short-term vs long-term profits.
- Manager: may pay more attention to short or long run profits.

Another difference are contracts  legal document or understanding that specifies a set of
actions that parties to the contract must undertake.
Markets and firms differ in the contracts that form the basis of exchange.

Contract:
Sale contract (for a car): transfers ownership: the new owner can use the car and exclude
others from its use.
Rental contract (apartment): does not transfer ownership (which would include the right to
sell it): it gives a limited set of rights over the apartment, including the right to exclude
others from its use.

- Products sold in markets: permanently transfer ownership

o Shot duration: until your right to return the product has expired.
o Interactions: short-lived, Implicit, not repeated.

- Contracts for labor markets (wage labour: system in which producers are paid for
the time they work for their employers) temporarily transfer authority over a
person’s activities from the employee to the manager/owner.
 o Long duration.
o Interactions: long term (friends)
o Required specific knowledge/skills: you also learn skills (that can be used
in different settings)  some skills may work different across firms  in
another firm, these skills may not be useful: relationship-specific/firm-
specific assets: sth a person owns or can do that has more value in the
individual’s current firm than in their next best alternative.
(Makes you more productive at that firm, but once the relationship
ends, value is lost to both sides)

3. Other people’s money: the separation of ownership and control

Owners claim their profit after paying other members of the firm  residual claimants:
person who receives the income left over from a firm after the payment of all
contractual costs (taxes, employees, managers, suppliers, creditors).
Managers (unless they are also owners) are not residual claimants. Neither are
employees.

Division or revenue has important implication: if the firm’s revenue increase because
managers or employees work well, the owners will benefit, but managers and
employees will not (unless they receive a bonus, promotion, salary increase).
- Small enterprises: owners are managers  they are in charge of decisions
- Large corporations: many owners (they own the shares: part of the assets of a firm
that can be traded. t gives the holder a right to receive a proportion of a firm’s profit
and to benefit when the firm’s assets become more valuable)  most of them: no
part in management: just a small group of specialized managers is in charge of
decisions.
o When managers decide on the use of other’s funds, this is referred to as
separation of ownership and control: attribute of some firms by which
managers are a separate group from the owners.  conflict of interest.

Conflict of interest: managers may choose actions that provide benefits for themselves at
the expense of the owners.
Ways in which owners can incentivize managers to serve their interests:
1. Contracts: managerial compensation dependable on the company’s performance.
2. Monitor managers’ performance  it can be difficult in large firms with lots of
shareholders.

Firm as an actor: maximize profits

- Owners have a strong interest in profit maximization: it is the basis of their wealth.
- Market competition penalizes or eliminates firms that do not make substantial
profits for their owners.

4. Other people’s labour

Before payment of taxes, a firm’s profit depends on:
1. Costs of acquiring inputs (try to minimize it)
2. Output
3. Sales revenues
 4.1. Incomplete contracts (contractual incompleteness)
Contract is incomplete:
- Some tasks depend on future (unknown) events  employees’ functions may
change depending on what may happen (rise of price, new projects)
- Some aspects of the job are difficult to measure
- Impractical for the firm to observe exactly how much effort each employee makes.
- The firm cannot contract an employee not to leave (employees retain the right to do
so)

Incomplete contract does not specify, in an enforceable way, all aspects that are relevant 
thus, paying the lowest possible way IS ALMOST NEVER THE FIRM’S STRATEGY TO REDUCE
COSTS OF ACQUIRING LABOUR.

However, they are not an issue everywhere:

Piece rate work: employment in which the worker is paid a fixed amount for each product
made  It gives workers an incentive to exert effort.
o Nevertheless, they are rarely used in most of today’s firms:
 Difficult to measure output in modern jobs
 Employees often work as part of a team
 If we incentive quantity, maybe we do not incentive quality, which it
may be even more important.
Bonuses are also a way to create incentives.

4.2. Workers’ effort

If firms can’t directly measure effort, why do they work hard?
- Work ethic
- Feelings of responsibility
- Gratitude for good working conditions (it does not usually last for long)
- Benefits for measurable output (it is not usually possible)
- Promotions
- Fear of being fired  two ways of making people fear about being fired:
o Google: offer services (childcare, health, legal services)  try to attract
and hold high-skilled workers who are so in demand in the market. If
workers are so in demand, they may not feel the necessity to work hard,
as they can change job easily. Thus, Google tries to attach them by
offering these services.

5. Employment rents
The net benefit of being employed that you missed out when you lose it. There are many
factors that influence it:
- Lost income while searching for job
- Costs required to start a new job (relocation)
- Loss of non-wage benefits (e.g., medical insurance for USA workers, or for Google
workers)
- Social costs (stigma)
Employment rents can benefit owners and managers in two ways:
- Employee is more likely to stay with the firm
- They can threaten to fire the worker: implicitly or explicitly
Owners can apply this also to the managers.

The higher the employment rent, the larger the fear of getting fired.

Calculating employment rents

a) Costs of working:
o Disutility of work: employees must spend time doing things they would
prefer not to (they would spend doing others)
o Commuting
b) Benefits
o Wage income
o Firm-specific assets: workplace friends, proximity to home maybe.
o Medical insurance
o Social status of being employed
She will be willing to -2 wage, in order to reduce the disutility of effort when employed.

In which of the following employment situations would the employment rent be high,
ceteris paribus?
In an economic boom, when the ratio of job-seekers to vacancies is low: cost of job loss is
low: you will easily find a new one –> economic rent is low

When the worker is paid a high salary because she is a qualified accountant and there is a
shortage of accountancy skills: will easily find a job  economic rent is low

5.1. Determinants of employment rent

Utility: numerical indicator of the value that one places on an outcome, such that higher
valued outcomes will be chosen over lower valued ones when both are feasible.

total employment rent=employment

rent per hour×expected lost hours of
work
=$10 per hour×1,540 hours
=$15,400

In some economies, people who lose

their job receives an unemployment
benefit or financial assistance from
government.
With unemployment benefit:
Reservation wage: lowest wage she is willing to accept in order to start working  8 (we
have to sum up disutility effort to unemployment benefit)
Employment rent per hour: Wage (12) – reservation wage (6) – disutility effort (2)
= wage (12) – unemployment benefit (6) – disutility effort (2)
= 12-8
= rent of 4 per hour  She will now lose $ per hour if she loses her job.

Total employment rent = employment rent per hour x expected hours of lost work time
= 4 per hour x 1,540 hours
= 6,160

Unemployment benefits usually run out eventually: families and friends will not be able to
help forever, and government unemployment benefits are often time-limited. If Maria’s
eligibility for unemployment benefits of $6 lasted only for 13 weeks, her reservation wage
would not be $6—she would not be indifferent between a job that paid $6 an hour and
unemployment. The employment rent would be higher and her reservation wage would be
lower, because the average level of benefits she could expect over the 44-week period of
unemployment would be much less than $6.

6. Labour discipline model

6.1. Wages and effort
Wage is the cost to the employer of an hour of a worker’s time. What matters for
production is not the amount of h, but the units of effort.
Effort is the input of the production process.

The employer should maximize the effort (efficiency units) that he gets per dollar of
wage cost, e/w  get as much effort per dollar paid. Indifference curves of the firm:
isocost lines for effort

- Slope of isocost curve =

vertical
distance/horizontal
distance= e/w = MRS =
rate at which employer is
willing to increase wages
to get higher effort.

- Slope = MRS = e/w

= 0.45/10
= 0.045

- The cost of effort is the same at all points on an isocost line

- Cost of a unit of effort: w/e
= 10/0.45
 = $22.22

- STEEPER line: lower cost of effort  higher

profits for employer
Cost of unit of effort in B = w/e
= 10/0.7
= $14.29 per unit

- Middle line: cost of a unit of effort was 22.22

 lower profits.

Minimizing the cost of effort

To maximize profits, the owner wants to obtain effort at the lowest cost. He will seek to get
onto the steepest isocost line possible. But because he cannot dictate the level of effort, he
has to pick some point on the worker’s best response curve.

Best response curve: optimal amount of effort workers will exert for each wage offered.
Represents the firm’s feasible frontier for wages and effort.
Slope of the feasible frontier = MRT. Initially, MRT is high (paying more increases effort a
lot). At higher the wage, lower the MRT (putting in more effort may not be possible or
difficult)
You may not increase your effort much more if your boss offers a higher wage when you are
already putting in a lot of effort.

A is the best the employer can do:

MRS=MRT  12 is the hourly wage the
employer should set to minimize costs and
maximize profits.

Points on higher isocost (B) would have

lower costs, but are infeasible

Profits are maximised at the steepest isocost line (MRS=MRT). Point A: higher wage than
reservation wage (paying 6 will be enough, but paying 12 will increase effort  it is good
both for the worker and the employer).
- The worker is better off than being unemployed (economic rent = 6)
Efficiency wage: wages set higher than reservation wage so workers will care about losing
the job and provide more effort. What matters for profits is e/w, the efficiency units per
dollar of wage costs, not how much an hour of work costs.

6.2. Owner- employee game

- Equilibrium: employer offers a wage and employee provides effort in response 
these strategies are a Nash equilibrium.
- Rent: employee provides effort in this allocation because she receives an
employment rent, she might lose if she were fired.
- Power: employer is able to exercise power over employee as employee fears losing
the employment rent  contributes to employer’s profit.

Large employment rent  large cost of job loss  worker puts in more effort to reduce
chance of being fired.

Payoffs:
- Firm: profit = worker’s output – wage
- Worker: employment rent

J  1 more dollar, high increase in effort

K  1 more dollar, low increase in effort.

At the very late, the feasible frontier may be flat.

6.3. Involuntary unemployment

Being out of work but preferring to have a job at the wages and working conditions that
otherwise identical employed workers have.
- There must always be involuntary unemployment in the labour discipline model 
both wages and involuntary unemployment have to be high enough to ensure
employment rent is high enough for workers to put in effort.

6.4. Factors shifting the equilibrium

Best response function will change in reaction to changes in:
- Utility of the things the wage can buy (inflation)  e.g., gas high price, commuting is
more costly (utility goes down). People will work less hard (curve shift to the right)

If utility goes up (more costly)  shift to the right.

- Disutility of effort
- Reservation wage
- Probability of getting fired (if it increased  left)
E.g., increase in unemployment rate  government aid is limited (long expected
unemployment situation)  the longer the unemployment time, the lower the
unemployment benefit per hour/week of lost work.

- It reduces the reservation wage  increases the employment rate per hour
- It extends the period of lost work time: this increases total employment rates (cost of job
loss)

For a given hourly wage (18), workers put in different levels of effort when the levels of
unemployment or unemployment benefit change.

- Rise in unemployment: more

effort for 18 wages  increase
profit-making for employer; wage
the employer would have to pay
to get an effort level (e.g., 0.6),
decreases.

- Rise in unemployment benefits:

opposite effects.

Sick days and unemployment rate in Germany

When unemployment is high, people work harder  more fear to lose the job
When unemployment is low, people work less hard  less fear to lose the job
- The relationship is not necessarily a positive one.

Alternative ways in which this pattern may happen no matter how many unemployment is
(people will equally work hard). How will we still get this graph?
- If people who are more absent for work are the first to get unemployed  when
unemployment is low, both harder workers and less harder workers have a job,
while when unemployment rise, lazy people get fired firstly.

7. Another kind of business organization

7.1. Worker-owned cooperative or cooperative firm
Firm mostly or entirely own by its workers, who hire and fire managers.
- Hierarchically organized
 - They need fewer supervisors and other management personnel  worker-owners
will not tolerate a shirking worker because he will reduce the profit share of the
other workers  work is done more intensively.
- Less wage inequalities
- Less lay-offs when economic crisis  they offer workers insurance (cut back on
hours for all rather than terminating the employment of some)
- Difficult to sustain

8. Principal-agent models

Ways in which people interact without a complete contract:

- People and bank lend money: unenforceable to get a repay if the borrower is unable
to pay.
- Managerial contracts do not enforce maximizing owner’s wealth.
- Rent contracts: liability for not maintaining the property is unenforceable.
- Insurance contracts cannot assure if people is not taking risks.
- Families purchase educational and health services  quality is not specified in a
contract (and would be unenforceable if it were).
- Parents care for their children with the hope they will reciprocate when parents are
old (but not contractual assurance).

Incomplete contracts arise when:

- Info not verifiable
- Relationship covers long periods of time
- Uncertainty
- Difficulties with measurement
- Judiciary is absent
- Preferences for omitting some info

Principal-agent capture interactions under incomplete contracts  This relationship exists

when one party (the principal) would like another party (the agent) to act in some way, or
have some attribute that is in the interest of the principal, and that cannot be enforced or
guaranteed in a binding contract.
- Agent takes an action that is hidden from the principal, which is why the principal
cannot verify it.
- A hidden action problem occurs when there is a conflict of interest between the
principal and the agent over some action that may be taken by the agent, which is
not subjected to a complete contract.
- Other examples: insurance company contracts (how a person behaves is difficult to
observe)