Modern Labor Economics Theory and Public Policy: The Neoclassical Firm and Theory of the Firm

MODERN LABOR ECONOMICS THEORY AND PUBLIC POLICY THEORY AND PRACTICE Industrial Organization 12THEDITION 5THEDITION 2 CHAPTER CHAPTER The Firm and Its Costs 1 19 March 2025

2.1 The Neoclassical Firm Microeconomists usually model a firm as a single entity with a clear goal that it pursues without any wasted effort. Neoclassical firm is represented by a production function that summarizes the relationship between inputs and output given the current technology. Each firm is assumed to maximize profits, making it possible to precisely predict its output and pricing decisions. Real-world firms are much more complex. Operate in many different product and geographical markets with many divisions and levels. First we consider the theory of the firm. Then we examine the structure of modern firms, and the profit- maximizing assumption. Analyzing conduct becomes more complicated without the assumption of profit maximization. Without profit-maximization, analyzing firm decisions such as pricing and advertising strategies requires an examination not only of market structure but also of the objectives of the firm. Thus we also consider what forces exist to keep managers from deviating from profit-maximizing behavior. 19 March 2025 2

2.2 Theory of the Firm 2.2.1 A Firm s Boundaries How does a firm organize production? Consider producing a computer. One possible way is to have a firm perform only one stage of production, such as assembly, buying all parts and then turning the completed product over to another firm for marketing. At the other extreme, production of all parts, assembly, and marketing could be done within one large firm. How does Dell or Apple decide when it will produce a necessary input internally and when it will rely on the marketplace? Coase (1937) argued that a firm would expand until the costs of undertaking a transaction internally were just equal to the costs of using the market to handle that transaction. The costs of using the market to conduct business are called transaction costs. Williamson built upon Coase s point, writing extensively on the importance of transaction costs and the types of organizational structures that have been developed to minimize transaction costs. 19 March 2025 3

2.2 Theory of the Firm 2.2.1 A Firm s Boundaries Advantages of the Market Williamson points out three production cost advantages of using the market. 1. If production of some input is subject to substantial economies of scale, yet an individual firm requires only a small quantity of the input, a single producer (of the input) can realize economies of scale and produce at a lower average cost. 2. Markets may aggregate related demands, allowing realization of economies of scope not available to a single firm. 3. If there are uncertainties in demand for a single firm s product, a market can reduce risk by pooling demands over many firms. Enables a firm to take advantage of competitive pressures to control its costs as a competitive market allocates resources efficiently and results in production at the lowest possible cost. In Williamson s words, Markets promote high-powered incentives and restrain bureaucratic distortions more effectively than internal organization. 19 March 2025 4

2.2 Theory of the Firm 2.2.1 A Firm s Boundaries Advantages of the Firm However, if transaction costs are high, firms are likely to turn to internal production. Transaction costs arise from activities such as: Searching for a supplier Negotiating with the supplier about contract terms Arranging for delivery Monitoring the quality of the input. Assumptions of transaction cost economics: 1. Bounded rationality. (Limits on knowledge, foresight, skill, and time constrain individuals ability to solve complex problems, so a firm cannot write a contract ahead of time that covers all contingencies.) 2. Opportunism. (Postulates that economic agents will try to mislead, disguise, and confuse others if it is to their advantage to do so and if they think such activities cannot be detected easily.) 19 March 2025 5

2.2 Theory of the Firm 2.2.1 A Firm s Boundaries Advantages of the Firm, continued. Transactions costs increase as it becomes more difficult to write a contract that eliminates the potential for opportunistic behavior. Three dimensions of transactions are important. 1. FREQUENCY The more frequent a firm s need for an input, the more the firm can save on transaction costs by internal production. 2. UNCERTAINTY Primary uncertainty: circumstances can change and no one can predict the future perfectly. Secondary uncertainty is caused by lack of communication. Behavioral uncertainty results from strategic or opportunistic decisions about disclosure of information. 3. ASSET SPECIFICITY Refers to the degree to which some assets are of value primarily to one firm. Assets can be specific as a result of geographic location, physical characteristics, or specialized human capital. Once the investment in a specialized asset has been made, buyer and seller are in a bilateral relationship in which each side has few other options. Likely to lead to difficult and expensive negotiations, possibly involving considerable bargaining and bluffs on each side. 19 March 2025 6

2.3 The Structure of Modern Firms Firm ownership takes several forms: sole proprietorships, partnerships, and corporations. Until the end of the 19th century, almost all firms were organized as sole proprietorships or partnerships. Two characteristics of proprietorships and partnerships were problematic as technology and industry structure began to change, unlimited liability and finite life. If a proprietorship or a partnership fails, the owner(s) can lose all assets, both business and personal. If one member of a partnership leaves or dies, the entire firm is automatically dissolved and a new partnership must be formed to continue the business. By number, sole nonfarm proprietorships and partnerships are still the dominant form of organization of firms in the United States (over 80%). Typically small, accounting for slightly more than 195 of total sales, and turnover is high. The vast majority of sales in the United States today are made by corporations. 19 March 2025 7

2.3 The Structure of Modern Firms A corporation is a separate legal entity, created by government charter and given certain powers, privileges, and liabilities. Ownership of a corporation takes the form of holding of shares of stock which can be bought or sold. The owners, the shareholders, are liable only for the amount they paid to buy the shares of stock initially. A corporation has an infinite life; it is not automatically dissolved when an owner dies or decides to leave the business. Corporations can raise large sums of money more easily than can proprietorships or partnerships. The ability to raise large sums of money became increasingly important in the late 1800s as the minimum efficient size of firms grew. 19 March 2025 8

2.3 The Structure of Modern Firms Table 2.1 shows the magnitude of some of today s largest corporations. Typical to rank corporations by their revenues Note the changes over time: petroleum refining companies have moved out of the top 10 for large part while companies in the healthcare industry have moved into this group. 19 March 2025 9

2.3 The Structure of Modern Firms 2.3.1 Separation of Ownership and Control When most firms were organized as sole proprietorships or partnerships, ownership and control of the firm were combined in the hands of one or a few people. As corporations developed, ownership and control separated. The owners of a corporation are its stockholders, but the day-to-day corporate business decisions are made by professional managers. Stockholders elect a board of directors to oversee the managers, ensuring that the owners interests are represented. In practice, the candidates for the board of directors for the vast majority of corporations are selected by the managers. Few stockholders typically attend a corporation s annual meeting. Some corporate boards of directors are more of a rubber-stamping body than an independent group vigilantly examining the decisions made by management and protecting the interests of the owners. According to a recent survey of a number of studies of ownership and control of U.S. corporations, the typical very large firm lacks a shareholder owning a dominant stake. 19 March 2025 10

2.3 The Structure of Modern Firms 2.3.2 Managerial Objectives When the firm is run by its owners, profit maximization and utility maximization for individuals are consistent goals, because the main source of income for the owners is the firm s profits. When ownership and control are separate, however, profit maximization and utility maximization may conflict as managers pursue objectives other than maximizing profits. Baumol: Managers may focus on sales rather than on profits if managing a large company adds to their sense of status and prestige. Rankings such as the Fortune 500 are typically made on the basis of sales. Salaries may be more closely tied to sales or to the growth rate of sales than to profits. Williamson: managers also get satisfaction from executive perks such as fancy offices, executive jets, and power breakfasts. Thus costs are higher than in the profit-maximizing model because money is spent on nice carpeting and art for the corner offices. 19 March 2025 11

2.3 The Structure of Modern Firms 2.3.2 Managerial Objectives In a world in which managers have some discretion over costs, costs may also be higher due to X-inefficiency. If managers are interested in living a quiet, peaceful life, they may not continually strive to find the least costly way of organizing production, handling materials, and, in general, doing business. As a result, costs are higher than necessary. Leibenstein defines X-inefficiency as the extent to which a given set of inputs do not get to be combined in such a way as to lead to maximum output. Managers may care most about protecting their jobs. If a manager perceives that the best way to avoid being fired is to earn the highest possible profits, then there is no conflict with profit maximization. But managers are likely to face asymmetric returns to risky decisions. The downside risk of a bad decision is extremely large, losing the job. The reward for a good decision is far less dramatic, such as a bonus. Because of this asymmetry, managers of large corporations may avoid projects with high expected profits but also high risk. 19 March 2025 12

2.3 The Structure of Modern Firms 2.3.3 Feasibility of Profit Maximization Some economists have focused their attention on the large size and structural complexity of modern firms. Most large corporations have thousands of employees, often organized into multiple functional components. Is it realistic to expect each of these thousands of employees to be striving in unison toward the goal of maximum profits? Different specialists are likely to have different goals or at least different ideas about how to achieve maximum profits. It is the top managers job to choose among conflicting objectives, but they cannot know everything known by the employees under them. May be difficult to accurately convey information. Because of organizational size and complexity, managers may opt for satisficing instead of profit maximizing. The satisficer sets a minimum acceptable level of performance below which he or she does not want to fall. To make decisions, a satisficing manager is likely to rely on a variety of rules of thumb. 19 March 2025 13

2.3 The Structure of Modern Firms 19 March 2025 14

2.3 The Structure of Modern Firms 2.3.3 Feasibility of Profit Maximization Another variation of rule-of-thumb pricing has firms setting prices as a fixed markup over invoice costs. For many years department stores such as Macy s and Bloomingdales priced by simply charging a fixed percent markup over the invoice cost of an item. If the markup was 100 percent, then a blouse that cost Macy s $50.00 would have a retail price of $100.00 If all of the major department stores followed this cost-plus pricing system, it would keep them from competing too aggressively on the basis of price. The system worked well for many years until discount stores such as Marshall s, T.J. Maxx, and Loehmann s began to underprice the major department stores by 20 to 50 percent. Early empirical evidence suggested that rule-of-thumb pricing is in fact a common phenomenon. 19 March 2025 15

2.3 The Structure of Modern Firms 2.3.3 Feasibility of Profit Maximization Hall and Hitch: 30 of 38 British firms surveyed in the 1930s claimed to use some rules to set prices. Fog: similar results for Danish firms. Kaplan, Dirlam, and Lanzillotti: half of a sample of 20 large U.S. firms used some rules to set prices. Large corporate giants such as General Motors, International Harvester, Alcoa, DuPont, Standard Oil of New Jersey, Johns-Manville, General Electric, General Foods, US Steel, and Union Carbide all priced to achieve a target rate of return. Concluded that [t]arget return on investment was probably the most commonly stressed of company pricing goals. However, these targets varied widely from 20 percent on invested capital for Alcoa, General Electric, and General Motors down to just 10 percent for International Harvester and 8 percent for US Steel. In most cases the firms actually earned rates of return that were significantly greater than the targets. General Motors, for example, averaged a 26 percent return between 1947 and 1955. 19 March 2025 16

2.3 The Structure of Modern Firms 2.3.3 Feasibility of Profit Maximization Why would the target rate of return used by such powerful corporations vary so widely? Because these firms faced widely differing elasticities of demand, they may have targeted widely differing returns on investment. The more inelastic the demand, the greater the rate of return. Heflebower looked at the empirical evidence available on full-cost pricing and concluded that firms that claim to be using a full-cost pricing method may be maximizing profits. In the words of Alfred Kahn, In many situations, target-return pricing simply does not make sense except as an ex post rationalization of profit maximization. Another serious criticism of the rule-of-thumb theory is that even in industries in which surveys have shown the existence of target pricing, more detailed studies have shown that other factors have a far greater effect on price. 19 March 2025 17

2.3 The Structure of Modern Firms 2.3.3 Feasibility of Profit Maximization What can we conclude about the use of rules-of-thumb pricing methods and the implications for the assumption of profit maximization? First, there is little doubt that many firms claim to use such methods. Second, these methods are almost always augmented by careful consideration of demand conditions. Finally, such rules may be fully consistent with profit-maximizing behavior if the rules merely reflect the best the firm can expect to achieve given current demand and cost conditions. 19 March 2025 18

2.3 The Structure of Modern Firms 2.3.4 Constraints on Managers Both constraints and incentives keep managers from straying too far from the straight and narrow path of profit maximization. One constraint is the possibility of stockholder revolt. Owners always have the option of selling shares of stock if they are unhappy with a company s performance. Some argue that this form of indirect control encourages managers to treat stockholders carefully and keep their interests in mind. A counterargument is that owners are unlikely to have complete information about alternative policies available to a firm, and thus the threat of revolt is usually only a weak constraint. Another constraint is the threat of a takeover. If current management is not maximizing profits, the firm s stock will sell for less than it would under profit-maximizing management Different management could purchase the firm s stock and begin to pursue a profit- maximizing strategy Thus the new management could earn large capital gains as the value of the firm rises above the purchase price. 19 March 2025 19

2.3 The Structure of Modern Firms 2.3.4 Constraints on Managers Assuming financial markets work well, such a takeover should occur whenever the potential gain in profits is greater than the costs of the takeover. The costs of a takeover bid are: Planning and legal costs Once a firm has become a target, its stock price may be driven up both by speculative purchases by investors hoping to make a quick profit and by competition among acquiring firms. Transaction costs arise from information problems. Insiders, such as the current management, have the most accurate information about whether profit is being maximized. An outsider may have trouble distinguishing between low profits due to poor management and low profits due to events outside the firm s control. Stockholders must also evaluate the claims of the group attempting a takeover, keeping in mind that the group has an incentive to reveal only information favorable to its attempt. Because of these costs, the threat of takeover is unlikely to be a completely effective constraint on managers. 19 March 2025 20

2.3 The Structure of Modern Firms 2.3.4 Constraints on Managers The product market may also constrain managers behavior. A firm that is not maximizing profits faces the possibility of being forced out of a competitive market as long as at least some other firms in the industry are striving for the highest possible profits. Incentives may also encourage managers to maximize profits. Tying executive compensation to profits through bonuses or stock options. Fraction of compensation that is equity-based has been increasing dramatically for firms of all sizes. The role of equity compensation and how to structure the packages is a topic of much debate, especially in reaction to the financial meltdown and recession that began in 2007. Researchers and policymakers are thinking about how to tie executive compensation to long-term company performance, reducing the incentives of executives to seek short-term stock gains even when doing so might involve excessive risk-taking. While this issue is not resolved, both theory and empirical evidence make it clear that executives do respond to incentives and that linking the value of their companies stock to wealth can affect corporate decision-making. 19 March 2025 21

2.3 The Structure of Modern Firms 2.3.4 Constraints on Managers The empirical evidence on whether firms maximize profits is extensive, yet inconclusive. Firms may do a better job of selecting the profit-maximizing price than of choosing the cost-minimizing levels of production, employment, or perks. The assumption of profit maximization is most likely to hold in the longer run and in those markets where firms face competitors. In the end, given the constraints on managers and the incentives for them to maximize profits, profit-maximizing behavior appears to be a reasonable first assumption to make in many cases. 19 March 2025 22

2.4 The Profit-Maximizing Output Level 19 March 2025 23

2.5 Cost Concepts: Single-Product Firms 2.5.1 Accounting Costs versus Economic Costs Accounting costs are the costs reported by firms in their financial reports following various bookkeeping conventions. The economic costof an input is the payment that input would receive in its best alternative employment. Draws on the concept of the opportunity cost of a good: the value of the resources used to produce that good in their best alternative use. It is economic costs that are relevant for economic theory of firm behavior. For some inputs, such as capital and labor inputs supplied by the owners of the firm, accounting costs and economic costs differ considerably. 19 March 2025 24

2.5 Cost Concepts: Single-Product Firms 2.5.1 Accounting Costs versus Economic Costs Consider a machine that is owned by a firm. An accountant would determine how much of the original price of the machine to charge to current costs by applying a standard depreciation formula. Economists consider the opportunity cost of using that machine for one hour of production, the rental rate (amount that another firm would be willing to pay for the use of the machine for an hour). By continuing to use the machine, the firm is implicitly choosing to give up the rental income it could earn from another firm. Then consider the cost of labor services supplied to a firm by its owner. An accountant would not count the value of the owner s services as part of cost. An economist, however, would ask what an owner (or entrepreneur ) could have earned in the best alternative employment. Because accounting and economic costs differ, accounting profits are generally greater than economic costs. If economic profits equal zero, then revenues just cover economic costs, indicating that all resources are receiving their opportunity cost. 19 March 2025 25