Figure 6. The owners, through their board of directors, decide the long-term strategies of the firm concerning how, what, and where to produce.
They then direct the manager s to implement these decisions. Each manager assigns workers to the tasks required for these decisions to be implemented, and attempts to ensure that the assignments are carried out. The green arrows represent flows of information. The upward green arrows are dashed lines because workers often know things that managers do not, and managers know things that owners do not.
Since owners or managers do not always know what their subordinates know or do, not all of their directions or commands grey downward arrows are necessarily carried out. It could tempt its customers with a special offer, but unlike the employer 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. Ronald Coase, the economist who founded the study of the firm as both a stage and an actor, wrote:.
What Public Companies Can Do
Coase pointed out that the firm in a capitalist economy is a miniature, privately owned, centrally planned economy. Its top—down decision-making structure resembles the centralized direction of production in entire economies that took place in many Communist countries and in the US and the UK during the Second World War. The difference between market interactions and relationships within firms is clear when we consider the differing kinds of contracts that form the basis of exchange.
A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use. A rental contract on an apartment does not transfer ownership of the apartment which would include the right to sell it ; instead it gives the tenant a limited set of rights over the apartment, including the right to exclude others including the landlord from its use. Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and to accept the authority of the employer over the use of his or her time while at work.
The employer does not own the employee as a result of this contract. If the employer did, the employee would be called a slave. To summarize:. Firms differ from markets in another way: social interactions within firms sometimes extend over decades, or even a lifetime. In markets, we shop around, so our interactions are typically short-lived and not repeated. One of the reasons for this difference is that working in a firm—as either a manager or an employee—means acquiring a network of associates who are essential for the job to be done well. Some of our workmates will become our friends.
Managers and employees also acquire both technical and social skills that are specific to the firm they work for. Oliver Williamson, an economist, termed these skills, networks, and friendships relationship-specific or firm-specific assets because they are valuable only while the worker remains employed in a particular firm. When the relationship ends, their value is lost to both sides. Think about how different this is to the social interactions in the market.
Although you may know the face or even the name of a person from whom you buy, or to whom you sell something, the relationship is typically temporary, in which case this knowledge has little value. This social aspect becomes important economically when economic changes disrupt social interactions. Imagine how your life as a shopper changes if your local grocery store closes tomorrow.
You would have to find a new place to shop, and it might take you a few minutes to learn where the various items you need are on display. Now imagine what would change if the company in which you work goes out of business tomorrow. You would lose your network of work associates, your workplace friendships, and your firm-specific social and technical skills would suddenly have become useless to you.
You might have to move to a new town. Your children would need to change school, so they would lose contact with their friends too. In Figure 6. The owners take whatever remains after revenues the proceeds from sale of the products are 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 unless they are also owners are not residual claimants. Neither are employees. This division of revenue has an important implication. This is one reason we consider the firm as a stage, one on which not all the actors have the same interests. In small enterprises, the owners are typically also the managers and so are in charge of operational and strategic decisions.
As an example, consider a restaurant owned by a sole proprietor, who decides on the menu, hours of operation, marketing strategies, choice of suppliers, and the size and compensation of the workforce. In most cases the owner will try to maximize the profits of the enterprise by providing the kinds of food and ambience that people want, at competitive prices.
Unlike Apple, the owner cannot outsource dishwashing or table service to a low-wage location. In large corporations, there are typically many owners. 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 decisions of managers affect profits, and profits decide the incomes of the owners. But it is not always in the interest of managers to maximize profits. They may choose to take actions that benefit themselves, at the expense of the owners.
Understanding a Company's Culture
Perhaps they will spend as much as possible on their company credit card, or seek to increase their own power and prestige through empire-building, even if that is not in the interests of shareholders. Even single owners of firms are not required to maximize their profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But unlike managers, when they lose profits as a result, the cost comes directly out of their pocket.
In the eighteenth century, Adam Smith observed the tendency of senior managers to serve their own interests, rather than those of shareholders. He said this about the managers of what were then called joint-stock companies:. The Wealth of Nations , Smith had not seen the modern firm, but he understood the problems raised by the separation of ownership and control. There are two ways that owners can incentivize managers to serve their interests.
The board has the authority to dismiss managers, and shareholders in turn have the right to replace members of the board. The owners of large companies with many shareholders rarely exercise this authority, partly because shareholders are a large and diverse group that cannot easily get together to decide something. Occasionally, however, this free-rider problem is overcome and a shareholder with a large stake in a company may lead a shareholder revolt to change or influence senior management.
When we model the firm as an actor, we often assume that it maximizes profits. This is a simplification, but a reasonable one for most purposes:. People participate in firms because they can do better if they are part of the firm than if they are not. As in all voluntary economic interactions, there are mutual gains. But just as conflicts arise between owners and managers, there will generally be differences between owners and managers on the one hand, and employees on the other, about how the firm will use the strength, creativity, and other skills of its employees.
Our focus here is how firms seek to minimize the cost of acquiring the necessary labour to produce the goods and services they sell. We have already seen in Unit 2 how firms might increase output without raising costs by adopting new technologies, and in Unit 7 we will study their sales decisions. Hiring employees is different from buying other goods and services. When we buy a shirt or pay someone to mow a lawn, it is clear what we get for our cash.
But a firm 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:. To understand the last point, consider a restaurant owner, who would like her staff to serve customers in a pleasant manner. Imagine how difficult it would be for a court to decide whether the owner can withhold wages from a waiter because he had not smiled often enough.
An employment contract omits things that both the employees and the business owner care about: how hard and well the employee will work, and for how long the worker will stay. Think of two or three jobs with which you are familiar, perhaps a teacher, a retail worker, a nurse, or a police officer. In each case, indicate why the employment contract is necessarily incomplete. Adam Smith, writing at the birth of capitalism in the eighteenth century, was to become its most famous advocate.
Karl Marx — , who watched capitalism mature in the industrial towns of England, was to become its most famous critic. Born in Prussia now part of Germany , he distinguished himself as a student at a Jesuit high school only by his rebelliousness. In he became a writer and editor for the Rheinische Zeitung , a liberal newspaper, which was then closed by the government, after which he moved to Paris and met Friedrich Engels, with whom he collaborated in writing The Communist Manifesto Marx then moved to London in At first, Marx and his wife Jenny lived in poverty.
He earned money by writing about political events in Europe for the New York Tribune. Marx saw capitalism as just the latest in a succession of economic arrangements in which people have lived since prehistory. Inequality was not unique to capitalism, he observed—slavery, feudalism, and most other economic systems had shared this feature—but capitalism also generated perpetual change and growth in output.
He was the first economist to understand why the capitalist economy was the most dynamic in human history. Perpetual change arose, Marx observed, because capitalists could survive only by introducing new technologies and products, finding ways of lowering costs, and by reinvesting their profits into businesses that would perpetually grow. This, he claimed, inevitably caused conflict between employers and workers.
Buying and selling goods in an open market is a transaction between equals: nobody is in a position to order anyone else to buy or sell. In the labour market, in which owners of capital are buyers and workers are the sellers, the appearance of freedom and equality was, to Marx, an illusion. Instead, the wage allowed the employer to rent the worker and to command workers inside the firm. Marx thought that the power wielded by employers over workers was a core defect of capitalism.
Capital is long and covers many subjects, but you can use a searchable archive to find the passages you need. Marx also had influential views on history, politics, and sociology. He thought that history was decisively shaped by the interactions between scarcity, technological progress, and economic institutions, and that political conflicts arose from conflicts about the distribution of income and the organization of these institutions.
He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities. These themes include the firm as an arena of conflict and of the exercise of power this unit , the role of technological progress Unit 1 and Unit 2 , and the problems created by inequality Unit Why is it not possible for firms just to pay employees according to how productive they are? This method of payment, known as piece rate , provides the employee with an incentive to exert effort, because employees take home more pay if they make more garments.
In the late nineteenth century the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. If piece rates are not practical, then what other method could a firm use to induce high effort from workers? How could the firm provide an incentive to do the job well, even though the worker is paid for time and not output? For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. For some employees, hard work is a way to reciprocate a feeling of gratitude to the employer for providing a job with good working conditions.
In other cases, firms identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group that is divided among team members. But in the background, there is another reason to do a good job: the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security. In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly.
If firms paid their employees the lowest wages they would be willing to accept, the answer would be no. Such a wage would make the worker indifferent between remaining in the job and losing it. But in practice most workers care very much. There is a difference between the value of the job taking into account all the benefits and costs it entails and the value of the next best option—which is being unemployed and having to search for a new job.
In other words, there is an employment rent. We can use the same reasoning in the employment of managers by the owners of the firm. The main reason owners wield power over managers is that they can fire them, and so eliminate their managerial employment rents. For example, the two leading economists of the early nineteenth century—Ricardo and Malthus—were political opponents. Ricardo often sided with businesspeople, for example in supporting freer imports of grain to Britain to reduce food prices and allow lower wages.
Malthus opposed him and supported the Corn Laws that restricted grain imports, a position favoured by the landed gentry. But the two economists both proposed the same theory of land rents, which we still use today. Even more striking is that two economists from different centuries and political orientations came up with similar ways of understanding the firm and its employees. In the nineteenth century, Marx contrasted the way that buyers and sellers interact on a market, voluntarily engaging in trade, with how the firm is organized as a top—down structure, one in which employers issue orders and workers follow them.
The nature of the firm , Both based their thinking on careful empirical observation, and they arrived at a similar understanding of the hierarchy of the firm. They disagreed, however, on the consequences of what they observed: Coase thought that the hierarchy of the firm was a cost-reducing way to do business. Like Malthus and Ricardo, Coase and Marx disagreed. But like Malthus and Ricardo, they also advanced economics with a common idea. Recall that an economic rent measures the value of a situation—for example, having your current job—compared to what you would get if the current situation were no longer possible.
To calculate employment rent—or in other words, the net cost of job loss—we need to weigh up all the benefits and costs of working compared with being unemployed and searching for another job. Even confining attention to the loss in wages, the cost is high. But how do we measure how high it is? Can we compare the economic situation of workers currently employed with the economic situation of unemployed people? No, because the unemployed are a different group of people, with different abilities and skills. Even if they were employed, they would be likely on average to earn less than people who currently have jobs.
An entire firm closing, or a mass layoff of workers, provides a natural experiment that can help. We could look at the earnings of workers before and after they lost their job during a major employment cutback. When a factory closes because the parent company has decided to relocate production to some other part of the world, for example, virtually all workers lose their jobs, and not just the ones who were most likely to lose their jobs through poor performance.
Louis Jacobson, Robert Lalonde, and Daniel Sullivan used such a natural experiment to estimate the cost of job loss.
They studied experienced not recently hired full-time workers hit by mass layoffs in the US state of Pennsylvania in The year was not a good time to be looking for work in Pennsylvania, but similar estimates from the US state of Connecticut between and for example suggest that even in better times, employment rents are large enough that workers would worry about losing them.
In which of the following employment situations would the employment rent be high, ceteris paribus? To determine her economic rent, we need to think how she would evaluate two aspects of her job:. Her disutility of work depends on how much effort she puts into her job. Suppose she spends half of her working time actually working, and half doing other things like checking Facebook. We represent this as an effort level of 0. This is her employment rent per hour.
The total employment rent or cost of job loss , depends on how long she expects to remain unemployed. We will suppose that if she loses her job she can expect to remain unemployed for 44 weeks before finding another. The analysis in Figure 6. Looking ahead from now taken as time 0 , she will continue to receive this wage for the foreseeable future if she keeps her job, indicated by the horizontal line at the top of the figure.
The difference between her wage and disutility of effort is the economic rent per hour that she receives while employed. If instead Maria were to lose her job at time 0, she would no longer receive her wages. This unfortunate state would persist as long as she remains unemployed, indicated by the horizontal line at the bottom of the figure. The expected duration of unemployment is 44 weeks, where she would have worked 35 hours per week.
That is how long she will remain without pay and without the disutility of working. The shaded area is her total cost of job loss from the spell of unemployment, that is, her employment rent. Her total employment rent is the employment rent per hour times the number of hours of work she will lose if her job is terminated. It is the shaded area in the figure. People who lose their jobs can typically expect help from family and friends while they are out of work. Also, in many economies, people who lose their jobs receive unemployment benefit or financial assistance from the government.
In poorer economies, they may be able to earn a small amount in informal self-employment. If Maria receives an unemployment benefit or income from any of these sources, it will partially offset the lost wage income. Unemployment benefits usually run out eventually: families and friends will not be able to help forever, and government unemployment benefits are often time-limited. For example, we have assumed that:. Redraw Figure 6. Specifically, assume:. When the cost of job loss the employment rent is large, workers will be willing to work harder in order to reduce the likelihood of losing the job.
Holding constant other ways that it might influence the employment rent, a firm can increase the cost of job loss, and therefore the effort exerted by its employees, by raising wages. We now represent this social interaction in the firm as a game played by the owners through their managers and the employees. As with other models, we ignore some aspects of their interaction to focus on what is important, following the principle that sometimes we see more by looking at less. On the stage of the firm, the cast of characters is just the owner the employer and a single worker, Maria. The game is sequential one of them chooses first, like the ultimatum game that we saw in Section 10 of Unit 4 and is repeated in each period of employment.
Here is the order of play:. The payoff for the employer is the profit. Employers typically hire work supervisors and may install surveillance equipment to keep watch on their employees, increasing the likelihood that the management will find out if a worker is not working hard and well. Here we will ignore these extra costs and just assume that the employer occasionally gets some information on how hard or well an employee is working. This is not enough to implement a piece-rate contract, but more than enough to fire a worker if the news is not good.
Maria knows that the chance of the employer getting bad news decreases the harder she works. We can think of this as the proportion of each hour that she spends working diligently the rest of the time she is not working. An effort level of 0. So she would not care one way or the other if her job ended. For Maria, effort has a cost—the disutility of work—and a benefit: it increases the likelihood of her keeping the job, and the employment rent. In her choice of effort she needs to find a balance between these two.
A higher wage increases the employment rent and hence the benefit from effort, so it will lead her to choose a higher level of effort. Just like the production functions in Unit 3, it shows how one variable, in this case effort, depends on another, the wage. Point J refers to the information in Figure 6. Effort per hour, measured on the vertical axis, varies between zero and one. If she is paid more, she provides more effort. The upward-sloping curve shows how much effort she puts in for each value of the hourly wage on the horizontal axis.
When the wage is low, the best response curve is steep: a small wage increase raises effort by a substantial amount. At higher levels of wages, however, increases in wages have a smaller effect on effort. Point J in Figure 6. The best response curve is concave. It becomes flatter as the wage and the effort level increase.
Theory of the firm
This is because, as the level of effort approaches the maximum possible level, the disutility of effort becomes greater. In this case it takes a larger employment rent and hence a higher wage to get effort from the employee. Seen from the standpoint of the owner or the employer, the best response curve shows how paying higher wages can elicit higher effort, but with diminishing marginal returns. The best response curve is the frontier of the feasible set of combinations of wages and effort the firm can get from its employees, and the slope of the frontier is the marginal rate of transformation of wages into effort.
So we can see that the firm would never offer the lowest wage possible, because she would not work. We have drawn the best response function in Figure 6. If the expected duration were to change, the best response function would change too. So for any wage, her best response would be to exert a higher level of effort.
Which of the following statements is correct? Maria is not in the situation that Angela faced when Bruno could order her to work at the point of a gun. Maria has bargaining power because she can always walk away—an option that, initially, Angela did not have. Maria chooses how hard she works. The best the owner can do is to determine the conditions under which she makes that choice. The owners and managers know that they cannot get Maria to provide more effort than is given by the best response curve shown in Figure 6. The fact that the best response curve slopes upwards means that employers face a trade-off.
They can get more effort only by paying higher wages. As we saw in Unit 2, to maximize profits, firms want to minimize the costs of production. In particular, they want to pay the lowest possible price for inputs. A company purchasing oil for use in the production process will look for the supplier that can provide it at the lowest price per litre, or equivalently, supply the most oil per dollar. Likewise, Maria provides an input to production, and her employer would like to purchase it at the lowest price. But this does not mean paying the lowest possible wage.
But what matters for production is not how many hours Maria provides, but how many units of effort: effort is the input to the production process. If Maria chooses to provide 0. The upward-sloping straight line in Figure 6. We will call this an isocost line for effort. We can also think of it as an indifference curve for the employer. At every point on this line the ratio of effort to wages is the same. The steeper line has a lower cost of effort, and the flatter line has a higher cost of effort. A steeper line means lower cost of effort and hence higher profits for the employer.
On the steepest isocost line he gets 0. On the middle line he only gets 0. The employer is indifferent between points on an isocost line. Like other indifference curves, the slope of the effort isocost line is the marginal rate of substitution: the rate at which the employer is willing to increase wages to get higher effort. To minimize costs, the employer will seek to reach the steepest isocost line for effort, where the cost of a unit of effort is lowest.
Use the analysis in Figure 6. To maximize profits, the owner wants to obtain effort at the lowest cost. He will seek to get onto the steepest isocost line possible. Could this be a point such as C? It is clear that by paying more the owner will benefit from a lower wage-effort ratio.
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At this point, the marginal rate of substitution the slope of the isocost line for effort is equal to the marginal rate of transformation of higher wages into greater effort the slope of the best response function. Points on steeper isocosts, such as Point B, would have lower costs for the employer but are infeasible. The employer cannot do better than this point: any point with lower costs, for example, point B, is infeasible. The employer minimizes costs and maximizes profit at the point where his MRS the slope of his indifference curve or isocost line equals the MRT the slope of the best response curve, which is his feasible frontier.
Leibniz: Finding the profit-maximizing wage. This is a constrained choice problem, similar to the one in Unit 3. What has the labour discipline model told us? When we think about the implications of the labour discipline model for the whole economy, it tells us something else, which may at first seem surprising:. There must always be involuntary unemployment. Being unemployed involuntarily means not having a job, although you would be willing to work at the wage that other workers like you are receiving. In developing our model we assumed that Maria could expect to be unemployed for 44 weeks before receiving another wage offer at the same level.
But the model implies that there must be an extended period of unemployment. She would be indifferent between keeping the job and losing it. So her best response would be an effort level of zero.
Employers would offer higher wages to ensure that their workers had something to lose and would therefore work hard. But with higher wages, they would not be able to offer as many jobs. Workers who lost their jobs would no longer be able to find new ones easily. Jobs would be scarce and it might take weeks or months to find another. The economy would have moved to an equilibrium with higher wages and involuntary unemployment. In equilibrium, both wages and involuntary unemployment have to be high enough to ensure that there is enough employment rent for workers to put in effort. Unemployment is an important concern for voters and the policymakers who represent them.
We can use this model to see how policies that governments pursue to alter the level of unemployment, or to provide income to unemployed workers, will affect the profits of firms and the effort level of their employees. If so, explain how. According to this figure:. Was it their initiative and innovative thinking? Was it their ability to rally support? Are the walls covered in stories or photos of customers and employees? The absence of those artifacts says something as well. How does the firm celebrate? What does it celebrate? How frequently does it celebrate?
Are there quarterly town hall meetings? Does the firm get together when new sales records or big customer orders are achieved? Is the concept of quality present in the culture? Do employees take pride in their work and the output of their firm? Are there formal quality initiatives in place, including Six Sigma or Lean? Are there regular opportunities to interact with top executives including the CEO? Is employee input sought for new initiatives including strategy?
Are the leadership roles filled with individuals who have been promoted from within? Does the firm tend to hire from the outside for senior roles? How does the organization innovate? Ask for specific examples. Be certain to explore what happens when innovation initiatives fail. How are big decisions made?
Do executives encourage decision-making at lower levels of the organization? Is cross-functional collaboration encouraged? Again, ask for examples. If you are hired into a new organization in a senior leadership role, respect the culture and heritage of the firm, even if the firm is struggling. Connect the change initiative to the core cause, purpose and values of the firm. Identify and draw upon key influencers inside the organization for support.
Instead of selling your idea to the entire organization at once, sell it to the influencers and gain their help in creating widespread support.