Manager and Firm-1

The manager and the firm
Readings
• Chapter 2 in Waschik, Fisher and Prentice, 2010. Managerial
Economics: A strategic Approach [2nd edition] Taylor & Francis.
[see the Reading List]
• Units 6.2, 6.3, 6.4, 6.13 and 6.15 in Economy, Society, and Public
Policy [the whole e-book is available online for free. The specific
Units can be found by clicking here.]
• Bonus material Unit 6.5
Outline
• Why do firm exist and the size of firms
• Increasing returns and marginal diminishing returns
• Division of labour, specialization and learning by doing
• The structure of the firm
• What is a firm and differences between firms vs markets
• Separation of ownership and control and the principal agent problem
• The market environment
• The role of the government
• Bonus material: the employment contract as incomplete
contract
• What is a firm?
• Why do firm exist?

What is a firm?
A firm is a group of workers and managers (employees), collectively
called labour, and a group of physical assets (like machinery in a
manufacturing operation or computers in a service sector firm),
collectively called capital, which produce goods and/or services (WFP,
2010)
Other definitions of firm may focus on the ownership structure.

A firm is characterised by:
• Owners own the capital and direct the activities of managers and
workers
• Owners receive the firm’s profits:
• whatever remains after the revenues, which are the proceeds from sale of the
products, is used to pay employees, managers, suppliers, creditors, and taxes.
On types of firms
There are three main types and are known with different names in different
jurisdictions and their difference is based on property and oblications of any
debts
• A proprietorship is an organization in which the owner is the residual
claimant. She has the rights to any profits, but the obligation of any debts.
• A second type is a partnership, where two or more individuals have
ownership rights.
• A third type is a corporation. With limited liability laws individuals are able
to buy a stake in a company that represents an upper limit on any poten-
tial losses they may incur. This makes ownership rights far more
transferable and expands the pool of investors.
• Learn more about corporations also known as limited liability companies
• https://www.bbc.co.uk/programmes/p058qrk3
Other kind of business organisations
• Very different organization and distinct from the firm as defined
in the cooperatives
• The workers are the owners of the capital and assets of the
organization
• The workers select managers who operate the business on a day-by-
day basis
• Profit are redistributed among the workers or re-invested
[Read Unit 6.13 in ESPP for more information about cooperatives]

Why do firm exist?
Firms exist because they are better suited to extract increasing

returns to scale:
- Firms are places organised in such a way that adding factors of
production (more labour or more capital) increases productivity
Increasing return to scale
Returns to scale is a concept directly related to the productivity of
factors of production.
• Suppose that some amount of labour and capital can be used by a
firm to produce a particular amount of output.
• Now imagine that the level of usage of all capital and labour
increases by 1 per cent.
• If total output increases by more than 1 per cent, then there exist increasing
returns to scale.
• If on the contrary total output increases by 1 per cent, then there exist
constant return to scale
• If on the contrary total output increases by less than 1 per cent, then there
exist decreasing return to scale
Sources of increasing returns to scale
• Division of labour
• Specialisation
• Learning-by-doing
• Thus, because of increasing returns to labour, more workers

may be able to produce more output working together than they
would if they worked alone.
• This creates an incentive for workers to join together, which in
turn results in the formation of firms
Limits to the size of firms
Increasing returns have limits:
• Diminishing marginal returns of labour

• Monitoring costs
Diminishing marginal product of labour
• We can imagine that cars could be produced with a single very

talented worker staffing the entire assembly line.
• By adding more workers to the line, the productivity of each worker
would increase, because of the benefits of division of labour (as
each worker can concentrate on a particular task), specialisation and
learning-by-doing (as workers get better at their assigned tasks with
experience).
• But there will come a point where adding more workers to the
assembly line will not increase efficiency, and will ultimately reduce
efficiency, as workers get in each others way.
Illustration of increasing and diminishing
returns
Some definitions
• Total Physical Product (TPP) is the total physical product

produced by a firm’s inputs within a given amount of time (in
units
• Average Physical Product (APP=TPP/L) is the physical product
produced per worker
• Marginal Physical Product (MPP=ΔTPP/ΔL) is the addition to
total product after employing one more unit of factor input.
Illustration of increasing and diminishing
returns
40
TPP
Tonnes of wheat produced per year
30 Number of
workers TPP
0 0
1 3
2 10
20 3 24
4 36
5 40
6 42
10 7 42
8 40
0
0 1 2 3 4 5 6 7 8
Number of farm workers
40
TPP
30 Maximum output Number of

workers TPP
0 0
1 3
2 10
20 3 24
4 36
5 40
6 42
10 7 42
8 40
0
0 1 2 3 4 5 6 7 8
40
TPP
30 Number of
workers TPP
0 0
1 3
2 10
20 3 24
4 36
5 40
6 42
10 7 42
8 40
0
0 1 2 3 4 5 6 7 8
40
TPP
30 Number of
workers TPP
Beyond this point 0 0
1 3
Output rises less and less rapidly
2 10
20 3 24
4 36
5 40
6 42
10 7 42
8 40
0
0 1 2 3 4 5 6 7 8
Monitoring costs
As firm grows, monitoring cost increases
• If we have many workers along the same assembly line, evaluating

performance becomes more difficult.
• Some workers may work harder, while others may shirk.
• Having more workers along the line may be a good thing, because
the production process benefits from increasing returns.
• However, the firm now needs to hire another type of worker or
supervisor (labour), in order to manage and monitor the performance
of workers on the line.
Decision-making structure of a firm
Shareholders/owners
Managers
Workers
Source, WFP (2010)
Source: ESPP
Firms vs markets
Think of the differences between firms vs markets
• This relationship between the firm and its employees contrasts with
the firm’s relationship with its customers.
• The bakery firm cannot text its customers to tell them to ‘Show up at 8 a.m.
and purchase two loaves of bread at the price of €1 each’.
• The firm could tempt its customers with a special offer, but unlike the
relationship with its employees, it cannot require them to show up.
• When you buy or sell something, it is generally voluntary. In buying or selling,
you respond to prices, not orders.
• The firm is different; it is defined by having a decision-making
structure in which some people have power over others.
Firms vs markets
• Firms represent a concentration of economic power: This is placed in
the hands of the owners and managers, who regularly issue directives
with the expectation that their employees will carry them out. An
‘order’ in the firm is a command.
• Markets are characterized by a decentralization of power: Purchases
and sales result from the buyers’ and sellers’ autonomous decisions.
An ‘order’ in a market is a request for a purchase that can be rejected
if the seller pleases.
Firms vs markets
• In a firm owners or their managers direct the activities of their
employees, who may number in the thousands or even millions.
• E.g., the managers of Walmart, the world’s largest retailer, decide on
the activities of 2.2 million employees, a larger number of people
than any army in world history before the nineteenth century.
• Walmart is an exceptionally large firm, but it is not exceptional in that
it brings together a large number of people who work in a way
coordinated (by the management) to make profits.
Owners,
managers and
workers
• Why does the need of
monitoring arise in the first
place?
• In many modern firms there is
a separation between
ownership and management
• Monitoring is necessary
Owners,
managers and
workers
• Why does the need of
monitoring arise in the
first place?
The green arrows

represent a problem of
asymmetric
information between
levels in the firm’s
hierarchy
Firms vs markets
The difference between market interactions and relationships within
firms is clear when we consider the differing kinds of written and
unwritten contracts that form the basis of exchange
• Contracts for products: When sold in markets, they permanently
transfer ownership of the good from the seller to the buyer.
• Contracts for labour (employment contracts): These contracts
temporarily transfer authority over a person’s activities from the
employee to the manager or owner.
Firms vs markets
• In an employment contract, the worker is paid according to the time
for which they work, not the specific tasks they undertake while
working.
• The manager does not own the employee as a result of th contract. If the
manager did, the employee would be called a slave. We might say that the
manager has ‘rented’ the employee for part of the day.
• A contract does not have to be written: It can be an understanding
between the manager and the employee.
Firms vs markets
• In markets for goods, we shop around; our interactions with
individual sellers or buyers are short-lived and often not repeated.
• An employment contract typically establishes a long-term
relationship that may last years, decades, or even a lifetime.
Outline
contract
Separation between ownership and
control
• The owners receive and claim the firm’s profits
• Total revenue – total cost
• Profit is whatever remains after the revenues, which are the proceeds from sale of the products, is used
to pay employees, managers, suppliers, creditors, and taxes.
• Profit is the residual.
• The owners claim it, which is why they are called residual claimants
• Managers and employees are not residual claimants (unless they have some
share in the ownership of the firm).
• This division of revenue has an important implication.
• If the firm’s revenues increase because managers or employees do their jobs well, the
owners will benefit, but the managers and employees will not (unless they receive a
promotion, bonus, or salary increase).
• This is one reason we consider the firm as a stage, one on which not all the actors have the
same interests
• Managers operate the firm while owners do not
Separation between ownership and
control
Example of conflict of interests in large corporations
• In large corporations, there are typically many owners. Most of them play
no part in the firm’s management. The owners of the firm are the
individuals and institutions (such as pension funds) that own
the shares issued by the firm.
• By issuing shares to the general public, a company can raise capital to finance its
growth, leaving strategic and operational decisions to a relatively small group of
specialized managers.
• The senior management of a firm is also responsible for deciding how
much of the firm’s profits are distributed to shareholders in the form of
dividends, and how much is retained to finance growth.
• The separation of ownership and control results in a potential conflict of
interest because the objectives of owners vs managers vs workers may
differ
Ways to resolve the conflict: Profit
Sharing
• Part of employees compensation can be based upon firm’s
performance or profitability
• Bonus systems based on the performance
• Since workers earn more if the company is more profitable, they have an
incentive to work harder, to ensure that the company earns higher profits.
• there are a number of studies which conclude that profit-sharing
plans can increase productivity by as much as 10 per cent.
• Such increases in productivity contribute to higher profitability, which
is in the interest of both the owners of the firm and workers who earn
a share of their income from profits. Evidence also suggests that
profit sharing can lower voluntary quits, dismissals and absenteeism
(see Jones et al. 1997)
Profit sharing problems
• Short run stock performance vs profitability in the long run
• For example, in firms listed on the stock market, managers’ pay rises and falls with the firm’s
stock market performance over a period as short as a quarter or a year; there are many ways
managers can boost the firm’s short-term stock market performance but damage the firm’s
profitability in the long run
• One is that they can structure contracts so that managerial compensation
depends on the performance of the company’s share price over a lengthy period
of time..
• The board has the authority to dismiss managers.
• But although the shareholders, who are the ultimate owners, have the right to
replace members of the board, they rarely do so. Shareholders are a large and
diverse group that cannot easily coordinate to decide something.
Principal-agent problem
• This conflict between
Principal-Agent Problem
owners and managers

can be generalized to a
principal-agent problem
in game theory
[Click on the picture for bonus material re principal-agent model]

Principal-agent problem
• The agent: This actor takes some action, such as working hard.
• The principal: This actor benefits from this action.
• A conflict of interest: This action is something the agent would not
choose to do, perhaps because it is costly or unpleasant.
• A hidden action: Information about this action is either not available
to the principal or is not verifiable.
• An incomplete contract: There is no way that the principal can use an
enforceable contract to guarantee that the action is performed.
Outline
contract
The market environment
By understanding all of
the interrelationships
described in this Figure
and determining which
are the most important
to a firm in a particular
market, the manager
gains important insight
into how managerial
decisions affect the
profitability of the firm
Outline
contract
The role of the government
• Encircling the market environment of the firm is the
government.
• The modern corporation may be affected by the government in
many different respects.
• There are regulations affecting how firms can dispose of wastes
produced as a by-product of operations or establish pollution control
measures
• There are regulations affecting how the firm treats its workers.
• There are taxes that firms have to pay, such as Goods and Services
Tax (GST), [Value Added Tax (VAT)] and Corporate Income Tax.
• Resolving markets failures
• Externalities
• Think of how regulation came to be from an historical point of view
• Unintended negative costs associated with the production of hazardous waste,
lead, pollution, etc. which are not accounted for by firms.
• Creating more failures
• Government failures
Conclusions
contract
Bonus Material Next
The employment relationship (Unit 6.5. ESPP)
• The profits received by the owners of the firm depend—among many
other things—on how hard and well those employees work.
• In firms, the manager sets the wage, hours of work and working
conditions, but also decides whether you lose your job (to some
extent) or are promoted
• But, as an employee, you also have some power in this relationship.
• You can quit your job, which will mean the manager has to incur the costs of
hiring someone else.
• You can also decide how much effort to put into your work, which is very
important to your manager.
• When thinking about issues we need to simplify the
complexities:
• Who are the agents of interest?
• Employee (worker) and the manager (owner/manager)
• What are the relationships?
• Wage labour contract
• For instance, thinking as an economist implies thinking about

the next best alternative for these economic agents, the
associated costs and benefits of their decisions
• The next best alternative for the firm this is to find, train and hire another
worker. For the employee this is to find another job. We can infer two
things from an employment relationship:
• The manager prefers to keep this employee: Owners need workers in order to produce
and to make profits. The alternative is to replace this employee with another
• The employee prefers working in this firm: The alternatives are seeking work elsewhere,
or being unemployed
• It is clear that both employees and managers benefit from the
employment relationship.
• But there is a principal agent problem: there is also a conflict of interest
between managers—owners and managers alike—and workers.
• The reason is that, in the simplest terms, owners want more employee
effort at a lower wage, while workers want a higher wage for less effort.
• It is very difficult to measure the amount of output an employee
is producing in modern knowledge- and service-based
economies: Think about an office worker, or someone providing
care at home for an elderly person.
• Employees rarely work alone: This means that measuring the
contribution of individual workers is difficult, for example a
team in a marketing company working on an advertising
campaign, or the kitchen staff at a restaurant.
• The employment contract is said to be incomplete.
The employment contract is incomplete
• A manager cannot write an enforceable employment contract that
specifies the exact tasks employees have to perform in order to get paid.
• This is for three reasons:
• The manager cannot see the future: Unforeseen future events mean the firm does
not know exactly what it will require the employee to do at the time it draws up a
contract of employment.
• It is expensive, and may be impossible, to measure effort: It is usually impractical to
observe exactly how much effort each employee makes.
• The contract may not be enforceable: Even if the firm somehow acquired this
information, it might not be able to use it in court.
• An employment contract omits things that both the employees and the
owner care about because they are central to the employment
relationship—including how hard and how well the employee will work,
and for how long the worker will stay.

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The manager and the firm

• Why do firm exist?

Other definitions of firm may focus on the ownership structure.

[Read Unit 6.13 in ESPP for more information about cooperatives]

Firms exist because they are better suited to extract increasing

• Thus, because of increasing returns to labour, more workers

• Diminishing marginal returns of labour

• We can imagine that cars could be produced with a single very

• Total Physical Product (TPP) is the total physical product

30 Maximum output Number of

• If we have many workers along the same assembly line, evaluating

Source, WFP (2010)

The green arrows

owners and managers

[Click on the picture for bonus material re principal-agent model]

• For instance, thinking as an economist implies thinking about

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