firm & production
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Firm & Production. EA Session 5: July 11 th , 2007 Prof. Samar K. Datta. Overview. Why does a firm exist? Decision to buy (subcontracting) or to make (internalization/ integration) Internal organization of the firm Handling separation between ownership and control - PowerPoint PPT PresentationTRANSCRIPT
Firm & Firm & ProductionProduction
Firm & Firm & ProductionProduction
EA Session 5: July 11EA Session 5: July 11thth, 2007, 2007Prof. Samar K. DattaProf. Samar K. Datta
Overview• Why does a firm exist?
– Decision to buy (subcontracting) or to make (internalization/ integration)
• Internal organization of the firm – Handling separation between ownership and control
• Technology & production function
• Classification of inputs & isoquants
• Production with one variable input (labor): Relation between AP & MP
• Production with two variable inputs & diminishing MRTS
• Returns to scale
• Some applications
Why does a firm exist?(not part of reading though)
• Answers provided by various economists– Coase (highlighting inside vs. market transaction)
• Choice of the least transaction-cost contractual arrangement to supply the commodity
– Negotiating with a representative of a coalition of resource owners (firm) for the complete commodity
– Negotiating with a large number of unitary firms for each component and assemblage of the commodity
– Alchian & Demsetz (shirking under team production)• Impossible to measure marginal product of each
member of the team• Creates incentive to shirk (reduce work effort without
proportional reduction in income) • To prevent shirking, members hire central agent to
monitor themselves• Monitor has low incentive to shirk as he gets a claim on
the firm’s residual income
Why does a firm exist? (not part of reading though)
– Barzel (highlighting measurability problem)• Environment characterized by costly information and outcomes
affected by chance• Due to decreasing returns from supervision, the one whose
contribution to common effort is the most difficult to measure will assume the role of entrepreneur
• Asymmetric information about entrepreneurial activity gives strategic advantage to entrepreneur
• Measurement problem solved by assigning entrepreneur a claim on the residual value of the joint venture.
– Williamson (highlighting role of specialized assets to conduct transactions – need to vest residual control and residual claim right on a single party)
• A specialized or custom-made product has asset specificity, which is vulnerable to opportunistic behavior by both buyers and sellers
• Ownership of specialized products or detailed long-term contracts are used to prevent problems of opportunistic bargaining
• Formalized structure of a firm is the specialized asset in this case• Therefore, the least transaction cost alternative is chosen
Why are capitalists the bosses?
• Who has got the maximum stake in the production process/system?
• With respect to whose efforts is there the maximum information failure problem?
• Which factor of production is a co-specialized asset along with the firm – land, labor, capital or the capitalist-entrepreneur?
Why does a firm exist?
– Two broad conditions, as cited by Dholakia & Oza:1. Q (x, y) ≥ Q (x) + Q (y), or, C (x, y) ≤ C (x) + C (y)
2. TC (x, y) ≤ TC (x) + TC (y)
Economies of scope thus working in terms of saving in • Either transformation costs (i.e., costs of inputs,
which enter directly into the production process)• Or transaction costs (i.e., costs of coordination &
monitoring of inputs directly entering into the production process)
Internal organization of the firm
• Unitary, partnership, or corporation• M (multi-divisional) form or U (unitary) form• How to manage separation between ownership
and control– Incentive-disincentive structure– Market for managers– Market for takeover
• Financing of the firm – debt/equity• Growth of the firm
– Organic (till marginal benefits, i.e. reduction in transaction costs, of internalizing an additional activity equal the marginal costs, i.e. increase of agency costs)
– Inorganic• Merger / Acquisition
– Vertical merger (value-addition through byproduct use)– Horizontal merger (economies of scope through co-
management of related products)
Possible objectives of the firm
1. Profit maximization2. Sales maximization3. Growth maximization4. Employment generation5. Satisficing behavior• In the long-run, no firm can ignore profit
considerations. Hence, profit maximization often looked upon as a reasonable description of firm behavior in reality.
The technology of production
• Production Process: Combining inputs or factors of production (land, labor, capital, organizational skill) to achieve an output, i.e., the transformation process
• Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs, given the state of technology.– Shows what is technically feasible when the
firm operates efficiently.
The Isoquant Map:Production with Two Variable Inputs
(L,K)
Labor per year
1
2
3
4
1 2 3 4 5
5
Q1 = 55
Isoquants showing all possible combinations of inputs that yield the same output
A
D
B
Q2 = 75
Q3 = 90
C
ECapitalper year
Importance of time period
• Short-run:– Period of time in which quantities of
one or more production factors cannot be changed.
– These inputs are called fixed inputs.
• Long-run:– All inputs are variable in the long run;
so there are no fixed inputs.
Production with One Variable Input (Labor): Relation between AP & MP
Laborper Month
Outputper
Month
60
112
0 2 3 4 5 6 7 8 9 101
A
B
C
D
8
10
20E
0 2 3 4 5 6 7 9 101
30
Outputper
Month
Laborper Month
AP = slope of line from origin to a point on TP, lines b, & c.MP = slope of a tangent to any point on the TP line, lines a & c.
• When the labor input is small, MP increases due to specialization (better utilization of fixed inputs).
• When the labor input is large, MP decreases due to inefficiencies (fixed factors become limited in supply).
Law of Diminishing Marginal Returns
Effect ofTechnological Improvement
Labor pertime period
Outputper time
period
50
100
0 2 3 4 5 6 7 8 9 101
A
O1
C
O3
O2
B
Labor productivitycan increase if there are improvements in
technology, even thoughany given production
process exhibitsdiminishing returns to
labor.
Marginal Rate ofTechnical Substitution
Labor per month
1
2
3
4
1 2 3 4 5
5Capital per year
Isoquants are downwardsloping and convex
like indifferencecurves, indicating declining MRS.
1
1
1
1
2
1
2/3
1/3
Q1 =55
Q2 =75
Q3 =90
Isoquants When Inputs are Perfectly Substitutable
Laborper month
Capitalper
month
Q1 Q2 Q3
A
B
C
Fixed-Proportions Production Function: Inputs are perfect
complements
Labor per month
Capitalper
month
L1
K1Q1
Q2
Q3
A
B
C
Increasing Returns to Scale
Labor (hours)
Capital(machine
hours)
10
20
30
Increasing Returns:The isoquants move closer together
5 10
2
4
0
A
Reasons:•Larger output associated with lower cost (autos)•One firm is more efficient than many (utilities)
Constant Returns to Scale
Labor (hours)
Capital(machine
hours)
Constant Returns:Isoquants are equally spaced because: • Size does not affect productivity• May have a large number of producers 10
20
30
155 10
2
4
0
A
6
Decreasing Returns to Scale
Labor (hours)
Capital(machine
hours)
Decreasing Returns:Isoquants get further apart due to:• Decreasing efficiency with large size• Reduction of entrepreneurial abilities10
20
30
5 10
2
4
0
A
Application: Malthus and the Food Crisis
• Why did Malthus’ prediction fail?
• Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand.
• Technology has created surpluses and driven the price down.
• Question: If food surpluses exist, why is there hunger?– The cost of distributing food from productive regions to
unproductive regions and the low income levels of the non-productive regions.
1) Growth in the stock of capital (both human and non-human) is the primary determinant of the growth in productivity.
2) Rate of capital accumulation in the U.S. was slower than other developed countries because the others were rebuilding after WWII.
3) Depletion of natural resources
4) Environmental regulations
Example: Explanations for Productivity Growth Slowdown
Co-existence of large & small units in the carpet
industry
• Economies of scale seem to be favoring larger units
• Advantages of product diversification as supported by market segmentation favoring smaller units