Ch. 20: The Firm

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Why Firms Exist

• A business firm is an entity that employs resources, or factors of production, to produce goods and services to be sold to consumers, other firms, or the government

• The market guides and coordinates individuals’ actions.

• The market guides individuals from the production of one good into the production of another good. It coordinates individual’s actions so that suppliers and demanders find mutual satisfaction at equilibrium.

The Alchian and Demsetz Answer

• Firms are formed when benefits can be obtained from individuals working as a team.

• Sometimes the sum of what individuals can produce as a team is greater than the sum of what they can produce alone.

Shirking in a Team

• Shirking occurs when workers put forth less than the agreed to effort.

• In situations where one person receives all the benefits from shirking and pays only a part of the costs, economists predict there will be more shirking than in situations where the person who shirks bears the full cost of his or her behaviors.

The Monitor

• A monitor or manager plays an important role in the firm. The monitor reduces the amount of shirking by firing shirkers and rewarding productive members of the firm.

• Who or what monitors the monitor?

• One solution: make the monitor a residual claimant.

Can Above-Market Wages Cause People to Shirk Less?

• Employees who are paid above-market wage rates are less likely to shirk or more likely to monitor themselves.

• The strong desire to keep their above-market-wage jobs cause them to be more conscientious in their work and to shirk less.

Ronald Coase on Why Firms Exist

• The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.

• Firms exist in order to economize on buying and selling everything.

• Firms exist to reduce transaction costs

Markets: Outside and Inside the Firm

• Economics is largely about trades or exchanges.

• In the firm theory, exchanges occur at two levels:

1. At the level of the individual coming together to form a team.

2. At the level of workers “choosing” a monitor.

Markets Inside Firms

• Each individual trades working alone for working in a team.

• Team members trade some control over their daily behavior in order to receive a larger absolute amount of the potential benefits that drew them together.

• Some people “buy” the monitoring services others “sell”.

The Objective of the Firm

• Separation of ownership from control in business firms has allowed managers to pursue their own goals, such as increasing the size of the firm or increasing the number of employees working for them, at the expense of the profit maximization goal of the stockholders of the firm.

• Satisficing behavior is directed to meeting some satisfactory (but not the maximum) target profit level.

Q & A

• What metaphor did Adam Smith use to convey the message that markets guide and coordinate individuals’ actions in an impersonal manner?

• Will individuals, in all settings, form teams or firms?

• Why would a person shirk more in a monitorless team than when working alone?

• Who, or what, monitors the monitor?

Types of Business Firms

• A proprietorship is a form of business that is owned by one individual who makes all the business decisions, receives the entire profits, and is legally responsible for the debts of the business.

Advantages and Disadvantages of a Proprietorship

Advantages• Easy to form and

dissolve.• All decision making

power rests in one person.

• The profit of the proprietor ship is taxed only once.

Disadvantages• The sole proprietor

faces unlimited liability

• Limited ability to raise funds for business expansion

• Usually ends with the death of the proprietor

Advantages, Disadvantages, and Examples

Population of Businesses

Partnerships

• A form of business that is owned by two or more co-owners, called partners, who share any profits the business earns and who are legally responsible for any debts incurred by the firm.

Advantages and Disadvantages of Partnerships

Advantages• Easy to organize• Usually an effective form of

business organization in situations where team production involves skills difficult to monitor.

• Benefits of specialization can be realized.

• Profit of the partnership is the income of the partners and only personal income taxes apply to it.

Disadvantages• Partners have unlimited

liability• Decision making can be

complicated or frustrating.• Voluntary withdrawal by a

partner from the firm or the death of a member of the firm can cause the partnership to be dissolved or restructured.

Advantages, Disadvantages, and Examples

Corporations

• A legal entity that can conduct business in its own name in the same way an individual does.

Advantages and Disadvantages of Corporations

Advantages

• The owners of the corporation are not personally liable for the debts of the corporation

• Continue to exist even if one or more owners die.

• Usually able to raise large sums of financial capital for investment purposes.

Disadvantages

• The profits are taxed twice

• Often subject to problems associated with the separation of ownership from control.

Advantages, Disadvantages, and Examples

Q & A

• What type of business generates the largest percentage of total business revenue?

• What are the advantages of a corporation?• What is the difference between a limited

partner and general partner in a partnership?• How might the owners of a corporation

solve the problems associated with separation of ownership from control.

The Balance Sheet Of A Firm

• Presents a picture of the financial status of a firm

• Includes assets, liabilities, net worth (also known as equity or capital stock).

The Balance Sheet of a Firm

Financing Corporate Activity

• Corporations sell bonds, a promise to pay for the use of someone else’s money.

• Bonds specify: the maturity date (the date the bond comes due); a dollar figure (the face value); a “coupon rate” (the interest rate of the bond)

• A share of stock is a claim on the assets of the corporation that gives the purchaser a share of the ownership of the corporation

Nonprofit Firms

• A firm in which there are no residual claimants.

• Examples include: churches, charitable organizations, colleges, and mutual insurance companies.

Nonprofit Organizations

• Because no residual claimants exist in a nonprofit firm, no one with the firm has an incentive to monitor shirking.

• There will be more shirking in a nonprofit firm than in a profit-seeking business firm.

• Top administrators in nonprofit firms will attempt to use “surplus” funds to make their lives more comfortable within the firm.

Public vs. Private Nonprofit Firms

• A private nonprofit firm is where citizens pay the cost. Ex: your local church.

• A public nonprofit firm is where taxpayers pay the cost. Ex: your local police department.

• Sometimes a nonprofit firm will receive some funds from taxpayers and some from private citizens who purchase the goods or services the nonprofit firm sells.

• A private nonprofit firm that doesn’t satisfy the persons who contribute the funds is more likely to go out of business than a public nonprofit firm that doesn’t satisfy its customers.