economics of organizations school of economics and business administration universidad de navarra

EconomicsEconomics of organizations of organizations

School of Economics and Business Administration

Universidad de Navarra

Professor: Brice Corgnet.

Email: [email protected]

Office: 2941.

Webpage: http://www.unav.es/ecoprof/bcorgnet

Course webpage:http://www.unav.es/empresa/eorganization

EconomicsEconomics of organizations of organizations

Grading policy:The final exam and the tests are mandatory, whereas the midterm is elective. In total there will be 2 tests, 1 midterm and the final exam.- If the student only takes the final and the tests, his/her grade will be a weighted average of:-Test 1: 10% of the final grade -Test 2: 10% of the final grade - Final exam, 80% of the final grade

- In the case of taking as well the midterm exam, his/her grade will be a weighted average of:- Test 1: 10% of the final grade- Test 2: 10% of the final grade- Midterm exam: 20% of the grade - Final exam: 60% of the final grade

Economics of organizationsEconomics of organizations

Grading policy:

Experiments:

We will also have 4 experiments in the classroom. - For each experiment each participant will obtain an extra 0.25 point (this rewards attendance and participation).If you participate in the 4 experiments you get 1 extra point to your final grade.


STUDENT’S PROFILE

1. Motivated!

2. Attentive.

3. Innovative.


Syllabus:

1. The nature of the firm

1.1. General knowledge of the firm1.2. Theories of the firm

2. Firms and Markets

2.1. Efficiency and limits of the market2.2. Transaction costs2.3. Behavioral approach to the hold-up problem2.4. Vertical and horizontal boundaries of the firm


Syllabus:

3. Managing the Firm

3.1. Selection of employees3.2. Motivation of employees3.3. The Behavioral approach of incentives3.4. Teamwork and cooperation


Syllabus:

1. The nature of the firm“A firm is a productive organization in which their members cooperate under some form of agreement.” Chandler (1992)


Alfred ChandlerAlfred Chandler

2. Firms and Markets“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.”

Coase (1937)


Coase, Nobel 1991Coase, Nobel 1991

3. Managing the Firm

“Coming together is a beginning; keeping together is progress; working together is success.”

Henry Ford


Henry FordHenry Ford

References: Most of the material for this course is included in the following essay:

1- Brice Corgnet and Pedro Mendi, Economics and Psychology of Organizations,lecture notes, University of Navarra, 2008.

2- Paul Milgrom and John Roberts,Economics, Organizations, and Management, Prentice Hall 1992.


Chapter 1Chapter 1The nature of the firmThe nature of the firm

School of Economics and Business Administration

Universidad de Navarra

Outline of the chapterOutline of the chapter

1.1. General knowledge about organizations1.1. General knowledge about organizations

1.2. Theories of the firm1.2. Theories of the firm Neoclassical Theory (End 19th century) Contractual Theory (In the 50s) Agency Theory (In the 80s) Behavioral Theory (In the 90s to now).

Definition Chandler (1992)

1. Firms are legal entities. That is, they may sign contracts with suppliers, distributors…

2. There is a central authority. People specialize in tasks, and they are coordinated by a central authority.

3. Firms are a pool of resources, both tangible (machinery, buildings, land) and intangible assets (knowledge, copyrights…).

1.1. General knowledge of the firm1.1. General knowledge of the firm

bcorgnet

The mafia is NOT a firm.

bcorgnet

A peña is NOT a firm.

bcorgnet

A club of bridge is NOT a firm

Basic structures of organizations

SalesManufacturing

Chief Executive

Finance

The functional form (U-form)



SalesProduction

Division A

Finance

Division B Division C

General Office

The multidivisional form (M-form)


Centro de Tecnología Informática

AOL Time WarnerProcter and Gamble, Daimler and Christler


SalesProduction

Division A

Finance& Accounting

Division B Division C

General Office

The hybrid form

SalesProduction


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NEC (Nippon Electric Company): PCs, peripherals, softwares.IBM: Software, semiconductors, consulting

Historical reference points

1850

Pre-industrialization Small Frims

1920 1960 1980



1850


Industrialization

Large firms Functional form

1920 1960 1980



1850 1920 1960

Large and diversified

firms Multidivisional

form

1980



Industrialization



1850 1920 1960 1980

Giant

Conglomerates


Large and diversified firms Multidivisional

form


Industrialization



1850 1920 1960 1980

Giant

Conglomerates


Large and diversified firms Multidivisional

form


Industrialization


Single business with multiple

products

Examples of conglomerates:- Lucky-Goldstar (cosmetics, electronics, telecommunication)- ITT (wastewater treatment, electronic components, hostels, car rentals, telecommunication)

- General Eclectric (Electricity, Media, heathcare, Finance).


1.2. Theories of the firm1.2. Theories of the firm

Definition

A theory of the firm is an abstract framework that provides an explanation for the existence of organizations.

The market is not everywhere even in the most market-oriented economic systems. But why?

Pure Market economy

Single-firm economy

M-form Organizations

U-form Organizations

Size firm

(Workers)

1 2-49 50-249

250-499

500-1999

2000-4999

>5000

Absolute Importance

(firms) 1.7 M1.7 M 1.1M1.1M 2630026300 32003200 20002000 318318 132132

Relative Importance

(% employees)4.3%4.3% 71.2%71.2% 9.9%9.9% 3%3% 6.3%6.3% 2.8%2.8% 2.5%2.5%


0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

80,00%

1 <50 <250 <500 <2000 <5000 >5000

% Workers


1.2.1. Neoclassical theory1.2.1. Neoclassical theory

Firms are reduced to production possibilities that are directly derived from the available technology.

Organzational aspects are ignored, since the goal is to explain the formation of prices in the economy.

Industrial Organization: evolution of the neoclassical Theory. Firms use their market power and behave strategically.

Assumption A (Perfect CompetitionAssumption A (Perfect Competition)A market exists for each good or service, and markets participants (consumers and producers) are in large number so that they do not affect the market outcomes.

Assumption B (Full Rationality)Assumption B (Full Rationality)B1) Agents have unlimited computational abilities.

B2) Agents are self-interested and maximize an objective function referred to as a utility function.

Assumption C (Perfect Information)Assumption C (Perfect Information)Agents have perfect information on prices and other agents' preferences (consumers) and technologies (producers).

1.2.1. Neoclassical theory1.2.1. Neoclassical theory

1.2.2. Contractual theory1.2.2. Contractual theoryCoasian theory and incomplete contractsCoasian theory and incomplete contracts

Contracts are an essential element in a market economy, since they allow efficiency gains from trade to be realized.

Definition of a contracti) A contract is a legally enforceable promise between the different parties of a transaction.ii) A contract is complete if it describes a course of action for every possible contingency. A complete contract specifies the rights and duties of the different parties in every possible situation.

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- Think about import-export activity in China. Not a simple transaction.- You buy at the market. There's a ticket. A contract.


Neoclassical theory: contracts are complete Contractual theory: contracts are typically

incomplete.

In reality, all contracts are incomplete since they do not include all possible cases. Why?


Example. When you register to a course at the beginning of the year, you sign a contract with the university. You pay the cost of a given course in exchange of lectures and a final grade. Is this contract complete? Why?


Consider the following cases.

1) The day of the final exam you came 10 minutes late? Should you be allowed to write the exam? Should you be penalized?

2) In the final exam a classmate that did not study for the course tries to cheat asking you the answer to a question. His attempt to cheat has been sufficiently awkward that it has been noticed by the person who proctored the exam. The proctor marked both exams with a cross. What should be your grade? How much should you be penalized?

3) (The Brice's case) You forgot the day of an exam that you studied. Should you be given a second chance?

4) Should you pass an exam with 4.9?


5) In an exam, you had to choose three questions out of four (English system). By mistake, you answered all of the questions. What should be your grade?

a)a) The average of the four questions.The average of the four questions.b)b) The best grade of the class since you answered more The best grade of the class since you answered more

questions than other people.questions than other people.c)c) The average of the three best questions that you The average of the three best questions that you

answered.answered.d)d) You should get a grade of zero for not complying You should get a grade of zero for not complying

with the rule of the exam.with the rule of the exam.


Contracts are incomplete mostly because people are boundedly rational (Assumption B1 does not hold). In that case, individuals are unable to foresee all possible situations associated to a contract.

Assumption B1’Assumption B1’ (Bounded Rationality)(Bounded Rationality) Agents have limited cognitive abilities.Agents have limited cognitive abilities.

For example, in the case of the contract that you write with the university when registering to a course it would be extremely costly to write down all the possible contingencies.

The abilities of people are especially limited when dealing with uncertainty.

Example (Kahneman and Tversky). Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which statement about Linda is more probable?(A) Linda is a bank teller.(B) Linda is a bank teller who is active in the feminist movement.


We know from elementary probability theory that the probability of a conjunction of events A&C cannot exceed the probability of either event A or C.

Bayes’ rule:

P(A&C) = P(A)×P(C or A) ≤ P(A) and,

P(A&C) = P(C)×P(A or C) ≤ P(C).

However, Kahneman and Tversky (1982) show in a sample of undergraduate students that 87% judged event B to be more probable than event A.


According to Coase (1937), the firm is a set of contracts (contract as the basic unit of analysis).

The goal is then to determine the boundaries of the organization. Which activities should be carried out internally, and which activities should take place in the market?

The firm manager compares the cost of using the market with the cost of internal organization. This determines the boundaries of the firm.


Williamson (1975, 1985) formalized the ideas of Coase by developing the Transaction Costs Theory.

The notion of transaction costs used to understand why some activities are carried out internally and why some others are carried out in the market.

1.2.2. Contractual theory1.2.2. Contractual theoryWilliamson theory and transaction costsWilliamson theory and transaction costs

Transaction costs can be divided into coordination costs (costs to reach an agreement between parties) and motivation costs (costs incurred to fulfill a contract).


Coordination costs Motivation costs

- Negotiation costs - Costs of supervising other parties

- Costs of designing a contract

- Costs to execute the contract

Transaction costs can be of different nature whether the transaction is performed through the market mechanism or inside the organization.

Market coordination costs consist in learning about consumers’ tastes, attitudes… Also, search costs appear whenever looking for suppliers or clients and prices may not be a costless piece of information.

Inside the organization, coordination costs appear in the transmission of information among the different decision makers.


We consider that there is an agency relationship when an individual, called the agent, acts on behalf of another individual, called the principal. The principal and the agent have diverging goals and different information.

1.2.3. Agency theory1.2.3. Agency theory

Principal

Agent

Action

Wage: w

Effort: e

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Examples: CEO-managers, managers-subordinates...

The firm, according to this view, is a nexus of agency relationships.

The agency theory analyzes the issues related to the delegation of authority and to the design of incentives.

Contracts are then designed to provide the agent with the optimal incentives in a context of asymmetry of information exante (before the transaction takes place) or expost (after the transaction is performed).

Assumption C’ (Asymmetric information)Assumption C’ (Asymmetric information) Parties involved in a Parties involved in a transaction do not have equal access to the relevant information.transaction do not have equal access to the relevant information.

1.2.3. Agency theory1.2.3. Agency theory

The agency theory implies that transactions will be performed within organizations as long as agency costs associated to the design of contracts are lower inside the firm than in the market.

There exists an agency relationship between students and their professors. Why?

a) We have diverging goals.

b) There is asymmetry of information.

1.2.3. Agency theory

The neoclassical model is based on the assumption that individuals are selfish and maximize their own material payoffs (Assumption B2).

Adam Smith (1759)

“How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.”

1.2.4. Behavioral theory1.2.4. Behavioral theory

Adam Smith, 1776 Adam Smith, 1776

Economic experiments stress that individuals:

- Care about others (altruism)

- Dislike very unequal allocations of resources (fairness).

- Reciprocal behaviors.

- Are envious.


bcorgnet

An experiment is an artificial setting in which a researcher control relevant variables in order to study a causal phenomenon.

Assumption B2 (Social Preferences)Assumption B2 (Social Preferences)

Agents do not only care about their own Agents do not only care about their own material payoffs but also about others’ material payoffs but also about others’ payoffs and actions.payoffs and actions.


bcorgnet

An experiment is an artificial setting in which a researcher control relevant variables in order to study a causal phenomenon.

Ultimatum gameThis game involves two players. Player A receives a sum of money from the experimenter (e.g. 10 euros) and decides the amount of money x to transfer to Player B. Player B has the option to reject the offer x and in this case both players’ payoffs are zero. If player B accepts the offer, the payoffs of players A and B are then respectively 10-x and x.


Under full rationality (Assumption B) Player A’s optimal action is to offer x = ɛ where ɛ > 0 is the smallest possible offer. This offer will be accepted by Player B if he is a profit maximizer.

- Results are very different from this prediction.

Average offer is equal splitting (x = 5) and offers x < 2 are rejected 70% of the time.

Individuals exhibit negative reciprocity (spiteful behavior) and are ready to lose money to punish low offers. Player A anticipates this behavior and tends to offer a positive amount of money.


Estados

Unidos

Japon Indonesia Israel Machiguenga

Dinero que repartir

10-160$ 80-120$ 10$ 10$

Oferta

Modal

50% 50% 50% 50%


United

States

Japan Indonesia Israel Machiguenga

Stake ($) 10-160$ 80-120$ 10$ 10$ 160$

Mode

Offer

50% 50% 50% 50% 15%


Ultimatum with chimpanzees


Bargaining experiments with Children (Fehr et al. 2008)


economics of organizations school of economics and business administration universidad de navarra

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