Intermediate Microeconomics

March 8, 2000

Class Notes (Chapter 11-18)



Chapter 11


Economic Change in a Competitive Industry






  1. Effects of an Increase in Demand
    1. Goal: to show the effect of an increase in industry demand on the firms and to show how firms cause industry supply to change. We can represent an increase in industry demand by a shift like that shown in Figure 11-1.
    2. Long run and short run industry supply
      1. Industry supply: the quantity that all firms taken together will supply at each price
      2. Short run analysis assumes that capital cannot be produced
      3. Long run analysis assumes that capital can be produced: means that all the firms that wanted to enter or leave an industry have already done so.
      4. Note that beginning with a long run equilibrium point, long run and short run supply curves cross at Q1 in Figure 11-2. But the SS curve is less elastic than the long run supply curve.
    3. Short run adjustment:
      1. Eliminating the short run industry shortage: The increase in demand causes shortage which implies that firms can earn profit by increasing price. If a firm discovered this, it would also discover that its current profit maximizing output is too low, since P will have risen but MC of producing its current output stays the same. So it will not only raise price but also produce more output. Firms will continue to adjust (i.e., raise) price and output until the industry shortage is removed. For the industry, this adjustment is shown at the price p2 and the quantity Q2 in the right panel of Figure 11-3, where SS crosses D2. We say the industry is in short run equilibrium.
      2. The firm's short run profit-maximizing position when the industry is in short run equilibrium. The increase in price enables firms to earn profit. The firm's short run profit maximizing position is shown in the left panel of figure 11-3. Industry price and the price faced by the firm is p2. The firm maximizes profit by producing q2. Its profit is abcd.
    4. Long run adjustment.
      1. Entry of new firms: Profits in the industry provides an incentive for firms outside the industry to enter. We assume that the entering firms build plants of the same size as the existing firms. Their entry causes the short run supply curve to shift to the right (because we must add up more firms' MC curves to get the short run supply curve). This causes a surplus at the short run equilibrium price of p2. Firms respond by reducing their price and output. This continues so long as the surplus remains. That is, it continues until price falls to p3 in the right panel of Figure 11-4, where SS2 crosses D2.
      2. Increase in costs faced by the firm: The entry of new firms cause the costs of production to rise faced by the firm. because we assume that this is an increase cost industry. The increasing cost industry assumption is represented by the fact that we have drawn the long run industry supply curve with an upward slope. This means that as more capital is produced to enable more firms to enter the industry, the cost of production faced by the firm rise. Thus, if Q1 is supplied in the long run, the cost curves faced by the firm are ac1 and mc1 but if Q3 is supplied in the long run, the cost curves faced by the firm are ac3 and mc3.
      3. Firm's position when there is long run industry equilibrium at Q3: price is higher an costs are higher than initially. But he firm is again in a break-even, zero profit situation. This is shown in the right panel of Figure 11-4.
      4. Number of firms: Note that each firm in the industry produces the same output as before. Since there is an increase in industry output and firms have entered, there are now more firms. Q3/q > Q1/q.
    5. Welfare effects
      1. Market effects and welfare effects
        1. Market effects: effects on price and quantity for the firm and industry in the short run and long run.
        2. Welfare effects: effects on well-being, as measured in money, of individuals
          1. Three roles: consumers, producers, and resource-suppliers.
          2. These roles receive surplus.
          3. Welfare effects are usually measured only for the long run.
          4. Economic rent: the income that owners of specialized resources receive because producers have a derived demand for their services.
            1. How economic rent varies with the demand for a resource: Figure 11-5 shows this.
          5. The surplus from exchange in long run equilibrium.: Figure 11-6 shows a step-by-step analysis. Note that each unit must be produced by the lowest cost producer and sold to the highest demand buyer. As more units are supplied producers must raise the rate of pay to the suppliers of specialized resources. This enables the owners of those resources that are most specialized to earn higher and higher rents.
          6. Ricardian Theory of Land Rent
            1. The higher the demand for a fixed amount of land, the higher the rent on the land: shown in figure 11-7.
            2. Theory of differential rent: As demand for the resources increases, (1) resources that are less superior are brought into use and (2) the more superior resources earn a rent that is higher than the less superior ones. The land at the margin - or marginal land - would be less fertile than all of the other land. Its price would be zero.
          7. Classifying the welfare effects of an increase in demand
            1. Consumers' surplus
              1. Consumers as a whole gain (compare abc with def in Figure 11-8.
              2. Some consumers lose: original consumers who would have bought at the lower prices.
            2. Economic rent
              1. Rises from efg to bcg = increase of bcfe.
            3. Producers: they gain only in the short run; in the long run, they again make zero profit.
  2. Effects of an Innovation
    1. Two types of innovation
      1. Discovery of a new good
      2. Discovery of a new method or production (We are concerned in this chapter with the second.)
    2. Market effects
      1. Assumption: the innovation is discovered by a single firm but not copied by any of the other firms in the industry.
      2. Initial effects on the firm. It reduces the cost curves faced by the firms and enables them to earn profit. This is shown in the left panel of figure 11-9. Costs fall from ac1 and mc1 to ac2 and mc2. The firm increases output to q2 and make profit of abdc. We assume that the firm is so small that its increase in output does not affect industry price.
      3. Effects in the long run
        1. Effects on the industry: In the long run, firms can copy the innovation. All of their costs curves fall, as do those of firms that consider entering the industry. This is represented by a lower LS curve as shown by LS2 in the right panel of Figure 11-10. We assume that the long run equilibrium for the industry is at p2 and Q2 in the right panel.
        2. Effects on the innovating firm (left panel of Figure 11-10): Industry price falls to p2 and costs rise from ac2 and mc2 to ac3 and mc3. Profit disappears and the firm breaks even (makes zero profit). It returns to producing q1.
        3. In our model, we have assumed that each firm stays the same size even though it is now using the new, lower cost method of production. This means that the number of firms must have risen. Q2/q1 > Q1/q1
    3. Welfare effects
      1. Consumers gain: Consumers' surplus rises from acb to afd in Figure 11-11.
      2. Resource suppliers may gain or lose: Compare the economic rent bcg with dfh in Figure 11-11. Whether they gain or lose depends on whether the reduced demand for specialized resources due to the innovation offsets the increased demand for resources due to the desire to produce a higher output.
  3. Competition and Consumer Sovereignty
    1. Definition: the idea that all choices in the market economy are carried out with the goal of producing goods for consumers.
      1. Sovereign is a king or sultan who rules a nation.
      2. The model of competition shows how
        1. firms respond quickly to change due to the profit incentive
        2. consumers and owners of resources are the gainers from competition.

Chapter 12

Price Controls



  1. Introduction
    1. Two Kinds of Price Controls
      1. Administered prices
      2. Price limits
        1. minimum prices: prices below which the law prohibits people from selling and buying.
        2. maximum prices: prices above which the law prohibits people from selling and buying.
  2. Determining Welfare Effects in the No Entrepreneur Economy
    1. Why output that is greater than or less than the competitive equilibrium is inefficient.
      1. Finding consumer benefits from the good and opportunity cost at the competitive equilibrium: Figure 12-1. Consumer benefit equals ace0; opportunity cost (benefits of using the resources elsewhere) is dce0.
      2. Why a higher output than q is inefficient: because the additional opportunity cost would exceed the gain in consumer benefit.(Figure 12-2)
      3. Why a lower output than q is inefficient: because the saving in opportunity cost would be less than the loss in consumer benefit.(Figure 12-3)
  3. Welfare Effects of a Minimum Price
    1. The New Equilibrium Price and Quantity ($18 and 500 units in Figure 12-4).
    2. The rationing problem
      1. Who the sellers will be cannot be determined by markets and prices
      2. We consider two cases
        1. Licenses to lowest-cost sellers.
        2. Licenses distributed randomly.
      3. Dividing sellers into groups (refer to Figure 12-5)
        1. Lowest-cost sellers: those willing to sell at $12.70 or less (mk)
        2. High-cost sellers: those willing to sell only if the price is greater than $12.70 (kS)
      4. 500 units are produced by low-cost sellers
        1. Economic rent is bckm.
        1. Deadweight loss is chk.
      1. 500 units are produced by highest-cost sellers (sellers represented by segment fe of the supply curve)
        1. Economic rent is def = jkm.
        2. Deadweight loss is bchkj.
      2. Rent-seeking: a person's attempt to benefit from an administrative decision or law even though the loss to others may be greater than his benefits.
      3. Rent-seeking costs: value of resources used in rent-seeking.
    1. Illegal Market
      1. Incentive to buy and sell in an illegal market: difference between lowest cost and the highest price that a consumer is willing to pay.
      2. Why the illegal market increases efficiency.
      3. Costs of using the illegal market
        1. transactions costs
        2. costs of avoiding being discovered and punished: risk cost
      4. Transactions costs: the costs due to time and energy used to find out whether a trade can be made plus the costs due to the time and energy spent negotiating for a better deal plus the cost of enforcing promises associated with the transaction.
    2. Government Farm Price Supports in the U.S.
      1. First policy: increase the demand by buying the surplus (left panel of Figure 12-6)
      2. Second policy: reduce the supply by paying farmers not to supply (right panel of Figure 12-6)
    3. Minimum Wage
      1. Definition: a law that prevents employers from hiring employees at a rate of wage per hour that is below some stated amount.
      2. Two assumptions:
        1. All workers are alike (homogeneous): used for simplification.
        2. Workers differ.
      3. A Simple Model Based on the Assumption That All Workers are Alike
        1. Deadweight Loss
          1. Assumption: workers who are employed at the minimum wage are those with the lowest opportunity cost. Loss equals shaded area in figure 12-7.
          2. Assumption: workers who are employed at the minimum wage include some whose opportunity cost is not lowest. Loss is greater than the shaded area.
        2. Unemployment - see Figure 12-7.
        3. Actual amount of unemployment and total wages.
          1. Two cases: demand and supply of labor are relatively flat and demand and supply are relatively steep.
          2. Demand and supply of labor are relatively flat (Figure 12-8)
            1. Amount of unemployment caused is high.
            2. Total wages earned decrease.
          3. Demand and supply of labor are relatively steep (Figure 12-9)
            1. Amount of unemployment caused is low.
            2. Total wages earned increase.
      1. A Model Based on the Assumption that Workers Differ
        1. Two kinds of differences
          1. Different qualities of labor.
          2. Jobs have different requirements.
        2. Effects
          1. Lowest skilled and least desirable workers would be laid off first; some may be able to improve their skills and desirability.
          2. Entry into labor force
            1. Labor force: workers who are either employed or searching for employment.
          3. Increase in independent contracting.
          4. Substitution of labor-saving techniques of production.
          5. Substitution of pay for fringe benefits.
          6. Incentives to violate the law.
  1. Welfare Effects of a Maximum Price
    1. The New Equilibrium Price and Quantity
    2. The Rationing problem
      1. Who the buyers will be cannot be determined by markets and prices
      2. Two cases
        1. Goods sold to highest-demand buyers
        2. Goods sold to lowest-demand buyers
      3. Dividing sellers into groups (refer to Figure 12-5)
        1. Lowest-cost sellers: those willing to sell at $12.70 or less (mk)
        2. High-cost sellers: those willing to sell only if the price is greater than $12.70 (kS)
      4. Goods sold to highest-demand buyers
        1. Consumers' surplus falls from aed to achg in Figure 11-12.
        2. Deadweight loss is ceh.
      5. Goods old to lowest-demand buyers
        1. Consumers' surplus falls from aed to fjk=abc.
        2. Deadweight loss is bcehg.
      6. Transactions costs and enforcement costs.
    3. Resale Market
      1. Resale from low demand buyers to high demand buyers
      2. Emergence of arbitragers and speculators
      3. Transactions costs
      4. Efficiency of having a resale market
    4. Black Market
      1. Incentive to form an illegal market
      2. Risk cost: costs of avoiding being discovered and punished (mentioned above).
    5. Rent Ceiling
      1. The argument that the gain to tenants offsets the loss to landlords
      2. Problems with the argument
        1. Deadweight loss, costs due to rationing, and enforcement costs
        2. The shape of demand and supply curves
          1. It is possible that the initial tenants as a group will lose if supply curve is steep (left panel of Figure 12-12).
          2. It is possible that the number of new tenants, who will compete with the initial tenants, will be large if the demand curve is very flat (left panel of Figure 12-13.
        3. Circumventing the law
          1. Fees: application fees and others
          2. Services: maintenance, provision of public goods
        4. Interpersonal comparisons of utility
    6. Illegal markets

Chapter 13

Monopoly in a Market Economy





  1. Introduction
    1. The argument that otherwise competing firms in an industry would join together in order to benefit from charging a high, monopoly price.
    2. Purpose of the chapter is to consider this argument.
  2. Individual Rights In a Pure Market Economy
    1. The initial right to profit from any action, so long as you do not harm others.
    2. The right to trade away rights: two examples
      1. The employment agreement
        1. An employee gives up his right to a share of the output in exchange for a wage, a piecework rate, or some combination. This agreement is discussed in chapter 14.
      2. The monopoly agreement
        1. A potential competitor gives up his right to profit by producing a good or resource that is in competition with the buyer (example of pizza sellers). Note that someone who sells her right to compete may choose to not allow the buyer of the right to resell it to someone else. We discuss the monopoly agreement in this chapter.
  3. Introduction to the Monopoly Problem
    1. Definition: one seller; exclusive position; no other sellers available to buyers.
    2. How to Achieve Monopoly
      1. Luck
      2. Possession of a specialized or superior ability
      3. Obtaining a transfer of rights from others: monopoly agreement
      4. Government intervention
        1. the example of a patent monopoly
        2. special privilege (airlines, cable TV)
    3. Price and Marginal Revenue
      1. Competitive firm compared with monopoly firm: assume that the firm is producing and selling a specific output; it decides to produce and sell one more unit. The monopoly firm must
        1. reduce its price in the next unit because it faces the industry, or market demand curve.
        2. reduce its price on all previous units because it (normally) cannot discriminate in price.
      2. The hypothetical case of a monopoly with no costs of production (e.g., a bridge with no maintenance or toll-collecting costs.
        1. Definition: price elasticity of demand: % change in quantity divided by % change in price - a measure of the responsiveness of quantity demanded to price changes.
        2. Elastic demand
          1. a decrease (increase) in price increases (decreases) quantity demanded by a greater % than the % decrease in price.
          2. a decrease (increase) in price increases (decreases) total revenue.
        3. Inelastic demand
          1. a decrease (increase) in price decreases (increases) quantity demanded by a lesser % than the % decrease in price.
          2. a decrease (increase) in price increases (decreases) total revenue.
        4. Why the monopolist maximizes surplus at the point on a straight-line demand curve where the price elasticity of demand equals 1.(figure 13-1)
          1. Monopoly can increase revenue by reducing price in the upper portion of the demand curve, where demand is price elastic.
          2. Monopoly can increase revenue by raising price in the lower portion of the demand curve where demand is price inelastic.
          3. If price is unit elastic, it would not be possible to increase revenue by raising or reducing price.
        5. Price elasticity and Marginal Revenue
          1. Where demand is price inelastic (lower part), marginal revenue must be negative.
          2. Where demand is price elastic (upper part), marginal revenue must be positive.
          3. Where elasticity is one, marginal revenue must be zero (figure 13-2).
        6. Important point: marginal revenue is less than price at each unit: make sure that you know why.
    4. Resource Misallocation Due to Monopoly
      1. Pareto Efficiency
        1. Definitions
          1. Pareto-efficient situation: one in which it would be impossible for anyone to be made better off without causing someone else to be worse off.
          2. A Pareto-inefficient situation is one in which we can imagine a change that would cause at least one person to be better off from some change yet cause no one to be worse off.
          3. Market failure: we can imagine a government policy that would make at least one person better off without causing someone else to be worse off.
      2. A Model of Monopoly Inefficiency
        1. Assumption: one monopoly industry operates in an environment of otherwise perfect competition. All other industries are perfectly competitive.
        2. Assumption: constant costs (mc=ac); this assumption is made for simplicity.
        3. Assumption: no price discrimination: firm must charge everyone the same price and charge the same price to a given buyer for each unit purchased.
        4. Surplus-maximizing position
          1. Quantity is the quantity at which mr = mc (point e and quantity qm in figure 13-3.
          2. Price is the highest price the firm can charge for the profit-maximizing quantity (pm in figure 13-3).
          3. Reduced consumers' surplus (loss of bcfd)
          4. Monopoly surplus (bced)
          5. Deadweight loss due to monopoly (cfe)
        5. Question: If the marginal value to a buyer at qm is greater than the marginal cost, why doesn't the monopolist produce one more unit and sell it to the person who values it the highest? (You do not truly understand the theory of monopoly unless you can answer this question.)
      3. "Unfair" Prices
        1. Economist is not concerned with whether a price is "unfair" but only with whether it is associated with inefficiency.
        2. Thus, in figure 13-3, the economist does not focus on the consumers who buy the units qm or less; he focuses on those who choose not to buy because the price is not lower than pm. The monopolist blocks resources from being used to satisfy the wants of these consumers in spite of the fact that the value of additional units of the good to them is greater than the marginal cost.
    5. Proposed changes that suggest that monopoly is a case of market failure.
      1. We can imagine a government price control that would prevent the monopoly from raising its price above mc.
      2. We can imagine laws that would deter monopoly practices (examples on p. 7).
  4. The Buyout Model of Monopoly
    1. Introduction
      1. The incentive to invent new products or variations of existing products, to discover a new method of production, to move to a location where there is high demand and no competition are all actions that lead to monopoly. But they are also actions that increase consumers' surplus and economic rent in the long run and monopoly surplus in the short run. These are not examples of market failure, although a model of them indicates a deadweight loss. Why? Because the deadweight loss cannot be eliminated without also reducing the incentive to do these things.
      2. Sources of Monopoly
        1. Efforts to escape competition by producing a new product, moving to a new location, producing a specialized skill (Microsoft, professional athletes, students in accounting): consumers benefit from this.
        2. Luck (not interested in luck in this book)
        3. Buyout (or, what is similar, cartelization)
    2. Definition and Preview
      1. Buyout monopoly: a monopoly that results when one producer of a product or user of a strategic method of production or resource is able to persuade his potential competitors to trade away their rights to compete.
      2. The buyout monopoly is possible when an industry contains significant economies of scale in production.
    3. A Simple Three-Person Model
      1. The hairdresser example: A (cost is $8) and B (cost is $10) compete as hairdressers for the business of C.
      2. The effort by A to buy B's right to compete.
      3. The equivalent incentive of C to bid for that right.
      4. The superior bargaining power of C; this is due to C's ability to block all gains from exchange by refusing to buy.
    4. Two Seller-Many Buyer Model
      1. Comparison of the surplus from competitive supply with monopoly supply in figure 13-4.
      2. Do the consumers in this model have the same superior bargaining power as C in the three person model? We must first consider transactions costs.
    5. Transactions Costs
      1. Costs of Identifying Preferences
        1. As individuals, the members of the group must determine their individual preferences -- the highest price each one is willing to pay for the good or service.
        2. Then someone in the group must determine the highest prices that all the other members are willing to pay and inform the others. He must acquire information about the others' preferences. This is he information problem of collective action.
      2. Costs of Reaching an Agreement
        1. The incentive to not reveal a high willingness to pay
          1. if others bid high enough, you can take a free ride
          2. if others do not bid high enough, your bid is unlikely to make a difference.
        2. The free-rider problem: agreements to make collective decisions to pay for a public good are not made because individuals have an incentive to not reveal their true preferences in order to take a free ride (i.e., to avoid paying a share of the costs of the decision).
      3. Policing Costs
        1. Definition: the costs of specifying the actions that the parties to the transactions agree to individually take, monitoring the transaction to see that the individuals actually take the specified actions, and administering specified penalties in the event that a party fails to act according to the agreement.
        2. Free-rider problem associated with (1) a collective specification of the actions that A must take, (2) collective monitoring, and, if necessary, (3) collective administration of a penalty.
      4. Conclusion
        1. Economies of scale lead to a small number of suppliers compared with the number of demanders.
        2. Transactions costs of joining together in a buyout are less for the smaller numbers.
        3. Buyout monopoly is more likely when there are economies of scale.
    6. Potential Competition: How potential sellers dampen the incentives for monopoly buyout
    7. Substitutes for Buyouts: Other Forms of Monopoly
      1. Horizontal Merger
        1. Definition: two or more previously independent competitors join together in a single company in order to establish a unified pricing and output strategy.
        2. Other types of merger
          1. vertical: example is a producer with a resource supplier or a distributor.
          2. conglomerate: two unrelated firms.
      2. The Trust
        1. Firms appoint a trust manager to make price and output decisions and turn over all profit to the trust. The trust manager distributes trust certificates (like shares of stock) that determine each firm's share of the trust's profit.
      3. Predatory Activity
        1. A wealthier and stronger firm aims to drive a less wealthy and weaker competitor permanently out of business.
        2. Unlikely to succeed unless there is little potential competition.
      4. Collusion
        1. Definition: an agreement by independently owned firms to follow policies that enable the firms as a whole to act as a single monopoly.
        2. Types:
          1. price-fixing agreement: each firm agrees to charge the same (high) price.
          2. market-sharing agreement: buyers are divided up according to some criterion (such as location) and apportioned to individual firms.
        3. Cartel: a set of firms that form a collusive agreement.
  5. Evaluating Proposed Solutions to the Monopoly Problem
    1. Retarding Invention and Innovation
      1. The buyout monopoly as a means of blocking the copying of a new invention.
    2. Difficulty of Judging Intentions
      1. The problems created by a policy that tries to take account of the intentions of a firm that monopolizes.
      2. Potential errors of judgment
      3. Wasteful actions by a firm that attempts to persuade judges that its intention was to protect an invention or innovation from copiers.
    3. Lack of Knowledge of Potential Competition
    4. Anti-Monopoly Policy is Costly
      1. Cost of writing the law.
      2. Cost of monitoring business.
      3. Cost of administering punishment.
      4. Additional costs associated with errors in judgment in these actions.
    5. Political Motivations of Government Agents
      1. Use of anti-monopoly policy to further the goals of politicians: to get reelected or to help their political parties.
    6. Manipulation and Bribery of Bureaucratic Agents
    7. Conclusion on Reducing the Deadweight Loss


Chapter 14

Modern Theory of the Firm



  1. Preliminary Ideas
    1. Team firm: a team production organization that is formed by means of employment compacts between employees and an employer who commands the work of the employees.
    2. Differences between commanding one's own work and commanding the work of others
      1. Communication is necessary
      2. Others may act opportunistically
      3. Incentives to invest in others' human capital are not optimal
      4. A governance structure may be needed to handle supervision and monitoring.
    3. Proposals to reward workers a share of the team firm's income according to working time rather than according to negotiated pay.
  2. Defining the Team Firm
    1. Definition contains three key parts, or characteristics
      1. Team production
      2. Exchange of rights to the output
      3. Limited authority of the employer over the employee
    2. The Three Characteristics
      1. Team Production
        1. Definition: a production process carried out jointly by means of the human capital of two or more individuals.
      2. Exchange of Rights to Output and Residual Claimancy
        1. The employee exchange his partial rights to the team output with the employer for pay.
        2. Residual claimant: in a team firm, it is the the owner of the right to the net income earned from team production.
      3. Limited Authority of Employer over Employees
        1. In a free society, the employee always has the right to quit an employer
        2. Posted employment bond: money that is set aside to compensate an employer in the event that an employee does not perform work as he promised.
    3. How the Team Firm Gets Created
      1. The combination of entrepreneurship of the employer, employee, and possibly a financier.
      2. How the financier takes on part of the entrepreneur role of the team firm.
  3. The Special Problems of Team Firms
    1. The Problem of Communication
      1. The various departments in a large manufacturing firm
        1. engineering
        2. purchasing
        3. marketing and sales
        4. production
        1. delivery
        2. maintenance and cleaning
        3. the CEO and his team (agents of the shareholders via the board of directors)
        4. shareholders
      1. The decision to cut out a department in the event that the communication problem makes it unprofitable.
    1. The Problem of Agency
      1. Definitions
        1. Principal: a role that wants an agent to make decisions that will benefit him.
        2. Agent:a role that a principal hopes or expects will make such decisions.
      2. The Principal and Agent in a General Context
        1. Contract and compact: an exchange agreement in which at least one party promises to perform actions in exchange for the action(s) that another (or others) promises to perform.
        2. Difference between a contract and a compact: a contract is in writing; a compact is not.
        3. A contract between a principal and an agent: a written agreement by an agent to perform partly unspecified actions that she promises will benefit the principal.
        4. The agency problem in a principal--agent contract from the viewpoint of the principal: the fact that because the principal cannot be certain about which actions the agent performs and/or how they may benefit him; he also cannot be sure that the agent will, in fact, act in good faith according to the contract or compact.
        5. Role of reputation: a principal may rely on this to make a decision about whether to hire an agent and what fee to pay.
        6. The agency problem in general from the viewpoint of economists: the economist's expectation that agents will supply fewer good faith efforts and principals demand fewer good faith efforts than is optimal.
        7. Reason for the agency problem: the principal will not hire an agent in some cases even though the marginal benefits of a good faith effort are greater than the marginal cost.
      3. The Agency Problem in the Employment Compact of a Team Firm
        1. Agency problem is important only when monitoring is costly an/or when the employer does not know the value of an employee's action.
      4. Related Ideas
        1. the agency problem in the supply of fire insurance. How it stops a potentially beneficial exchange from occurring.
        2. the moral hazard problem in the team firm
          1. to shirk: to work less or in a different way from what an employer expects.
          2. how it stops a potentially beneficial exchange from occurring.
        3. the moral hazard problem in fire insurance
          1. how it stops a potentially beneficial exchange from occurring.
        4. adverse incentives: incentives that lead individuals to perform actions that are non-optimal or to fail to perform actions that are optimal.
    2. Investments in Firm-specific Resources
      1. Preliminary Ideas
        1. Definition of a firm-specific resource: a resource that is valued much more highly if they are used with other complementary resources in a specific team firm than they are if they are used in other employments.
        2. Investment in economics vs. investment in finance.
      2. Non-Optimality of an Investment in General
        1. Optimal amount of investment: every investment that is know to be profitable is carried out.
        1. Why investment is non-optimal: the knowledge may be possessed by someone who is either unable or unwilling to provide the guaranty necessary to insure lenders that they will be repaid in the event the knowledge is wrong and the investment fails to yield the expected profit.
        2. the guaranty inefficiency of investment: inefficiency due to this reason.
        3. Means of reducing these inefficiency: various credit middleman activities.
      1. Investment in Material Resources vs. Human Resources
        1. Because the employer cannot own a human resource, he cannot be certain that he will be able to command the use of the resource after his investment in it.
      2. Inefficiency in the Production of Firm-Specific Human Capital
        1. Definition of firm-specific human capital: knowledge and skills that have greater value if they are used to complement the other resources of a specific team-firm than if they are used in some other enterprise.
        2. Assumption: employer knows which investment can be profitable; employee does not.
        3. Apparent Inefficiency: freedom from slavery makes investment in employee's firm-specific human capital inefficient.
  1. The Governance Structure
    1. Preliminary Ideas
      1. Definition of governance structure: the set of interpersonal relationships through which decisions relating to engineering, purchasing, production, marketing, delivery, maintenance, etc. are made.
      2. Two extremes
        1. One financier-owner makes all decisions
        2. Owners and financiers set up a military-type bureaucracy
    2. Goals of a governance structure
      1. Solve the communication problem: Ways that an employer can deal with it
        1. employ assistance, troubleshooters, communication specialists.
        2. set up meetings to facilitate communication.
        3. promote norms and rules to encourage cooperation.
      2. Solve the agency problem: Ways that an employer can deal with it
        1. employ various monitoring techniques, such as supervisors, spot inspections, cameras, and spies.
        2. offer the employee a share of the profit
        3. promote an environment of moral responsibility and loyalty
          1. hire employees that have a greater degree of these qualities.
          2. demonstrate a sense of employer responsibility toward employees.
          3. show leadership by supplying local public goods.
        4. There is no magic recipe. Which methods are best depends on the circumstances.
      3. Raise the profitability of employer investment in firm-specific human capital
        1. Means of reducing the inefficiency: time-graduated pay structure.
        2. Types of time-graduated pay structures
          1. pension plan
          2. employer-financed savings plan with time-increasing rights to withdraw.
      4. The general aim of a governance structure
        1. The general aim: each team member should make every contribution to the team effort for which the additional revenue or cost-saving due to his contribution is greater than the additional money he would have to be paid to compensate him for the effort.
        2. Two examples:
          1. the bricklayer
          2. the home seller
        3. The principle of optimal incentives
        4. Impossibility of building a governance structure that is in complete accord with this principle
          1. an employer cannot know every possible action that an employee could perform and that would benefit the team.
          2. monitoring employees is often expensive.
    1. Governance and the Financial Structure of a Corporation
      1. Preliminary Ideas
        1. We are concerned with a widely held corporation: a corporation that has many stockholders.
        2. We assume that all shares of stock are voting shares.
      2. From Birth to a Going Concern
        1. The founders of a firm obtain a corporation license, draw up an initial set of plans, and issue shares of stock.
        2. Stockholders elect board of directors.
        3. The board of directors appoint CEO.
        4. As corporation grows, its stock begins to be bought in sold in a stock market.
      3. Division of Profits and Uncertainty-Bearing in a Corporation
        1. Decisions about profit
          1. pay dividends on the basis of stock ownership.
          2. reinvest, which usually raises the value of a share of stock.
        2. liquidation: selling off the assets, paying the liabilities, and distributing the difference, if any to stockholders.
        3. uncertainty bearing: stockholders bear no liability if the liabilities exceed assets after a liquidation; some of the creditors must bear the uncertainty.
      4. The Stock Market
        1. What determines the price of shares: beliefs on the part of prospective buyers and sellers.
        2. How reinvestment of profit affects the price of a stock.
      5. Separation of Ownership from Control?
        1. Fact: stockholders of a widely held corporation own it; the CEO controls it.
        2. The idea of stockholders are either rentiers or gamblers, who take little interest in controlling the corporation.
        3. But: if the CEO does not control it well -- if his governance structure does not enable him to earn an otherwise possible profit -- the prices of the shares will fall. The corporation will become a takeover target for someone who aims to get control over more than fifty per cent of the shares, replace the CEO, change the governance structure, and turn the loss into a profit. This will raise the price of the shares and enable the takeover artist to earn a profit from his action.
  1. Objections to the Right to Freely Negotiate and Determine the Conditions of the Employment Compact
    1. How Employees May Gain from the Employment Compact
      1. employer may be a superior appraiser of resources.
      2. employer may build a superior governance system.
      3. employer bears all the uncertainty.
      4. employer pays in advance of the final sale of the product.
      5. employer bears all the risk of unpredictable conditions of the natural environment.
    2. Advantages of Team Production Usually not Available in a Worker-Manager Firm
      1. The Strict Worker-Managed Firm
        1. characteristics
          1. workers can select a manager.
          2. all income must be shared; thus the manager must earn the same as each worker.
        2. results
          1. The manager has only a weak incentive to produce the knowledge needed to improve the team's performance and to adjust to changing demand and cost conditions.
          2. The firm cannot have a governance system because all income must be shared.
          3. Workers would have to bear all uncertainty. If a law was passed to remove this uncertainty-bearing, the team firm would find it difficult to get a loan to finance production. Income for the team could not be realized until the output was produced and sold.
        3. Why become a manager?
          1. a manager would have the power to choose production-sales plans that yield benefits that are hidden from others.
      2. A Democratic Worker-Managed Firm with Variable Pay Rates
        1. characteristics
          1. workers can select a manager
          2. workers can set whatever rules and pay they want
        2. results
          1. The results depend on the governance structure that the workers set up to govern the manager's actions.
          2. Basic problem: Workers not sufficiently motivated to
            1. identify and set the best work and pay conditions for a manager
            2. build the best governance structure to govern the manager
            3. to provide optimal monitoring.
          3. Reason for the problem: adverse incentives (see the theory in the text).
    3. Socialism vs. Capitalism