Notes on Firm: Owners, Managers, and Employees

The Firm: Owners, Managers, and Employees

Unit Overview

• This unit explores how interactions among firm owners, managers, and employees influence wages, work effort, and profits.

New Concepts

• Division of labor
• Separation of ownership and control
• Firm-specific assets
• Incomplete contract
• Employment rent
• The Labor Discipline Model
• Involuntary unemployment

Core Elements of Firms

• Firms are a central component of a capitalist economy.
• Key players within a firm:
  • Owners
  • Managers
  • Employees
• Concepts:
  • Economic rents
  • Principal-agent problem
  • Incomplete contracts
  • Asymmetric information

Context for This Unit

• The model of bargaining within firms is built on several assumptions:
  • Gains from trade exist (Unit 1).
  • Firms adopt technologies with the lowest costs (Unit 2).
  • Wage increases have generally led workers to work less (Unit 3).
  • Collective projects can result in social dilemmas (Unit 4).
  • Voluntary contracts determine surplus size and sharing (Unit 5).
• This unit explains:
  • How wages and profits are determined.
  • How the surplus is shared between owners and workers.

6.1 Firms, Markets, and the Division of Labor

• The division of labor is coordinated in two primary ways:
  1. Firms:
     • Different departments within a firm produce components of goods (e.g., Apple hires programmers, engineers, and retailers).
  2. Markets:
     • Different firms bring components together through market interactions (e.g., Apple purchases LCD screens from other firms).
• Firms buying and selling final products on the market allow producers' products to reach consumers.

Herbert Simon (1916-2001)

• Political scientist and economist, Nobel Prize winner (1978) for research into decision-making within economic organizations.
• Addressed the question of why firms hire workers.
  • Firms contract work when tasks are easily specified.
  • Firms hire workers for uncertain tasks difficult to write into a contract.

Capitalist Firms as Planned Economies

• In markets, people respond to prices.
• In firms, people follow orders.
• Ronald H. Coase (1937): The distinguishing mark of the firm is the suppression of the price mechanism.
• A capitalist firm is a miniature, privately-owned, centrally-planned economy with a concentration of power.

Coordination of Work

• Hierarchical structure:
  • Board of Directors oversees Owners.
  • Managers direct Workers.
• Information flows are asymmetric.
• Directions/commands are issued from the top down.

Contracts and Relationships

• Contracts for Products
  • Permanently transfer ownership from seller to buyer.
  • Social interactions are generally short-lived.
• Contracts for Labor
  • Temporarily transfer authority over a worker’s activities to management.
  • Social interactions can extend over decades.
  • Lead workers to develop firm-specific assets (skills, networks, friendships).

Contracts and Relationships: Economic Implications

• The social aspect of markets compared to firms has important economic implications.
  • If a local grocery store closes, finding a new one is relatively easy.
  • If a company closes, an employee loses:
    • Their job.
    • Their network.
    • Firm-specific skills (transferability issues).
    • Cost of search for a new job.
    • Potential relocation costs.

6.2 Other People’s Money: The Separation of Ownership and Control

• Owners (residual claimants) profit from the firm’s performance.
• Workers and managers benefit from promotions, bonuses, or salary increases when the firm does well.
• Large corporations separate ownership from control.
• Adam Smith (1776): Managers of other people's money may not be as vigilant as owners.

6.3 Other People’s Labor

• Firms aim to maximize profits (Units 2, 6, 7, 8, and 12) and minimize the costs of acquiring labor.
• Hiring employees is complex.
• Sales revenues depend on:
  • Costs of inputs (including labor).
  • Outputs.
  • Sales.

Incomplete Labor Contracts

• Labor contracts are typically incomplete because:
  • Firms don’t know what they will need a worker to do in the future.
  • Observing each employee's job performance is too costly.
  • Even if firms could observe effort, it might not be the basis of an enforceable contract.

Complete Labor Contracts

• Complete labor contracts (e.g., piece-rate contracts) are rare because it is difficult to:
  • Put monetary values on many forms of output.
  • Measure individual worker output.
• When contracts are incomplete, paying the lowest possible wage almost never minimizes a firm's labor costs.

Karl Marx (1818-1883)

• Marx argued that capitalists pay wages to rent workers' time and command them inside the firm.
• He claimed the