The Organization of the Firm

1
The Organization of the Firm

• The Multi-Plant Problem
• Cost-Volume-Profit Analysis
• Managerial Decisions
• Securing Inputs and Transaction Costs
• Managerial Compensation
• Worker-Management Relations

2
Cost Elasticity

• Cost Elasticity Percentage change in total cost
  associated with a 1 change in output.
• Change in TC / Change in Q
• Note the dependent and independent variable.
• Interpretation
• Ec lt 1 Increasing Returns to Scale
• Ec 1 Constant Returns to Scale
• Ec gt 1 Decreasing Returns to Scale

3
Long-Run Average Cost

• Capacity Output level at which short-run
  average costs are minimized.
• If a firm moves beyond capacity the firm may
  want to consider building a larger plant.
• BE ABLE TO ILLUSTRATE THIS STORY IN THE SHORT-RUN
• Minimum Efficient Scale Output level at which
  long-run average costs are minimized.
• BE ABLE TO ILLUSTRATE LONG-RUN AVERAGE COST AND
  IDENTIFY THE LEVEL OF OUTPUT CORRESPONDING TO MES.

4
Firm Size and Plant Size

• Multi-plant Economies of Scale Cost advantages
  from operating multiple facilities in the same
  line of business or industry.
• Multi-plant Diseconomies of Scale Cost
  disadvantages from operating multiple facilities
  in the same line of business or industry.

5
The Economics of Multi-Plant Operations

• Elements needed for problem
• Equation for Demand Curve
• Short-run Total Cost Function
• Steps in Solving the Problem
• Solve for profit maximizing output, price, and
  profit.
• Solve for average cost minimizing output.
• Solve for MC when firm produces at capacity.
• Set MR equal to MC at capacity to determine
  optimal multi-plant operation.
• Determine the optimal number of plants.
• Determine price and profit when firm employs the
  optimal number of plants.

6
Cost-Volume-Profit Analysis

• Cost-Volume-Profit Analysis Analytical
  technique used to study the relations among cost,
  revenues, and profits.
• Breakeven Quantity A zero profit activity level
• TR TC
• PQ TFC AVCQ
• TFC P AVC Q
• Q TFC / P-AVC
• Profit Contribution P AVC

7
CVP Analysis Example

• Price 80 AVC 60
• TFC 20K
• Desired Profit 40K
• Q Fixed Cost Profit Requirement / Profit
  Contribution
• Q 20,000 40,000 / 20
• Q 3,000 units
• Given price, cost conditions, and desired profit,
  firm will need to produce 3,000 units.

8
Degree of Operating Leverage

• Degree of Operating Leverage Percentage change
  in profit from a 1 change in output.
• DOL change in profit / change in Q
• DOL Elasticity of Profit
• DOL at a given level of output
• Q(profit contribution) / Q(profit
  contribution) Total Fixed Cost
• OR P-AVC / P-ATC

9
Limitations of CVP Analysis

• Assumes selling price is constant. Each time the
  selling price changes the analysis must be
  completed again.
• Assumes that average variable cost is also
  constant. If this is not true, then the analysis
  is not particularly useful.

10
Methods of Acquiring InputsSpot Exchange

• Spot Exchange an informal relationship between
  a buyer and seller in which neither party is
  obligated to adhere to specific terms for
  exchange.
• This is often used when inputs are standardized
  so effort in finding the best input is not
  needed.

11
Methods of Acquiring InputsAcquiring Inputs Via
Contract

• Contract a formal relationship between a buyer
  and seller that obligates the buyer and seller to
  exchange at terms specified in a legal document.
• Contracts can reduce uncertainty, but increase
  the transaction costs incurred by the firm.

12
Methods of Acquiring InputsInternal Production

• Vertical Integration a situation where a firm
  produces the inputs required to make its final
  product.
• Vertical integration (alternative definition)-
  various stages of production of a single product
  are conducted by a single firm.
• Motivation Reduces Transaction Costs

13
Transaction Costs

• Transaction costs - the expenses of trading with
  others above and beyond the price. i.e. the cost
  of writing and enforcing contracts.
• Transaction costs determine whether markets are
  internalized or allowed to remain external to the
  firm.

14
More on Transaction Costs The Work of Oliver
Williamson

• Four basic concepts that underlie transaction
  costs analysis.
• Markets and firms are alternative means for
  completing related sets of transactions.
• The relative cost of using markets or a firms
  own resources should determine the choice.
• The transaction cost of writing and executing
  contracts across a market is a function of
• the characteristics of the involved human actors
• the objective properties of the market
• In sum, both human and environmental factors
  impact the transaction costs across firms and
  markets.

15
More from Williamson

• Purpose of this analysis is to identify the set
  of environmental and human factors that explain
  both internal firm and industrial organization.
• Key environmental factors
• Uncertainty and number of firms
• Key human factors
• Bounded rationality and opportunism

16
Bounded Rationality and Opportunism

• Bounded rationality - the limited human capacity
  to anticipate and solve complex problems.
• Opportunistic behavior - Taking advantage of
  another when allowed by circumstances.
• High transaction costs
• Specialized products The creation of specialized
  products, where only a single buyer and/or seller
  exists, can lead to opportunistic behavior. This
  provides an incentive for vertical integration.
• Changing market conditions Bounded rationality
  and uncertain market conditions make the writing
  and enforcement of contracts involving future
  conditions undesirable for both parties. Such
  high transaction costs increases the likelihood
  of vertical integration.

17
Market vs. Internal Production

• Labor theory Wages Marginal Revenue Product
• Marginal Revenue Product Marginal Revenue of
  Output (MR) Marginal Product of Labor (MP)
• However, for this to be true for each worker a
  firm would need to measure MP.
• What if a firm cannot measure MP? Then a worker
  can reduce effort an still maintain the same
  wage.
• When monitoring costs are high, a firm has an
  incentive to sub-contract work.
• Why? For independent workers the wage (profit) is
  closer linked to productivity.

18
More Benefits from Vertical Integration

• In addition to transaction costs, vertical
  integration is also motivated by two additional
  considerations.
• Vertical integration provides assurance of
  supplying inputs/outputs in a market that may be
  unstable.
• Threatens potential entrants by raising entry
  barriers (aluminum example)

19
The Principal-Agent Problem

• A principal is the person who wants an action
  taken. In the work environment, this is the
  owner of the firm.
• The agent is the person who takes the action. In
  the work environment, this is the worker.
• If motivations differ between the principal and
  agent, and information is not perfect, a
  principal-agent problem exists.
• A specific example is the issue of moral hazard.
  Moral hazard occurs when the agent can take
  actions that the principal cannot directly
  observe that will reduce the welfare of the
  principal. For example, consider shirking.
• How can the firm limit shirking?

20
Difficulty of Vertical IntegrationShirking of
Workers

• Shirking - the behavior of a worker who is
  putting forth less than the agreed to effort.
• Efficiency Wages Paying the worker a wage above
  the market wage.
• Why is this necessary? Because workers can vary
  productivity, a firm may need to pay higher wages
  to ensure higher levels of output.
• Why would firms pay efficiency wages? In other
  words, why do higher wages elicit higher
  productivity.
• a. The Gift exchange hypothesis
• b. Worker turnover
• c. Worker quality

21
Shirking Defense

• How do firms prevent the manager from shirking?
  Make the manager a residual claimant.
• Residual claimant - persons who share in the
  profits of the firm.
• How do firms prevent workers from shirking?
• Profit sharing mechanism used to enhance
  workers efforts that involve tying compensation
  to the underlying profitability of the firm
• STOCK OPTIONS, etc..
• Revenue sharing mechanism used to enhance
  workers efforts that involve tying compensation
  to the underlying revenues of the firm
• SALES COMMISSIONS, TIPS, etc...
• NO INCENTIVE TO LOWER COSTS

22
Teams and Productivity

• Teamwork is employed when a team of individuals
  can produce more than the sum of individuals
  working alone.
• Observing individual productivity is difficult,
  so shirking can occur The Free Rider Problem
• Profit Sharing If team members share in the
  profits of the firm, then they have an incentive
  to monitor other team members. If the incentive
  to monitor exceeds the free-rider effect, profit
  sharing can increase productivity.

23
More Defense Piece Rates

• Piece-Rate Compensation Employee is paid
  according to productivity.
• Such a compensation plan will increase
  productivity.
• Will only work if productivity can be measured.
• Problems
• Teamwork will diminish.
• Quantity is easy to measure, quality is not.
  Thus quality can suffer with this compensation
  plan.

24
Subjective Evaluations

• Why are subjective evaluations employed? To
  encourage innovation, dependability, cooperation,
  etc...
• Subjective evaluations can lead to rent-seeking
  by workers, or actions taken to re-distribute
  resources from others.
• Subjective evaluations can also be quite
  inaccurate. Inaccurate evaluations can distort
  incentives.

25
The Role of Management

• What is the primary role of the manager?
• To prevent shirking, which limits the production
  of the firm.
• In essence, employees employ the manager to raise
  the return to the firm.
• Implications If the manager is poor, employees
  will leave. If the returns of the firm do not
  accrue to the employees, the employees will
  leave.
• Remember, the labor market is like any other
  market. Exchange takes place by both parties
  because benefits exceed the costs.

26
The Objectives of Management

• Managers seek to maximize utility (A.A. Berle and
  Gardner Means)
• Focus of these authors is on the separation of
  ownership and management, which arose due to the
  rise of the corporation.
• How would this impact market behavior? Studies
  have shown that managerial control is less
  profitable than owner control. Managers are
  more risk adverse, due to an inability to
  diversify.
• A related view.... Managers seek to satisfice
  (Richard Cyret, James March and Herbert Simon)
• In this class we assume that firms seek to
  maximize profits. This is a simplification.
• WHY DO WE NEED TO ANSWER THIS QUESTION? We need
  to know the motivation of the people we study.