Invisible Hand
P
S
D
Q
• The use of market
(price) mechanism
in allocating
resources or goods.
• Buyers and sellers
trade directly with
each others.
Visible hand
• The use of the
entrepreneur in
directing the
allocation of
resources (or
goods).
A Firm
• An organization in which the use of
resources is directed by a manager (director)
(i.e. directed by a visible hand), instead of
being directed by the invisible hand of the
market mechanism (i.e. directed by signals
of the market price).
Does a Firm exist?
• A boy provides shoeshining service in the street.
• It depends on whether the
boy is directed by
somebody to shine shoes in
the streets.
Does a Firm exist?
• A father orders
his son to clean
up the floor after
a party.
• Yes
Does a Firm exist?
• A housewife buys
some fresh seafood
in the market and
some cooked food
from fastfood shop.
• Yes/No
Questions
Have you ever tried seafood in Cheung
Chau? You can have two options if you
want to enjoy seafood dinner in Cheung
Chau:
Questions
Option 1:
Buy the seafood in the market and then
bring them to the restaurant. And the
restaurant will cook the seafood for you,
charging a ‘cooking fee’.
Questions
Option 2:
Like the restaurants in TST or Mongkok,
you just walk into the restaurant and order
the dishes you like, saving the trouble of
buying seafood from the market by yourself.
Questions
1.Why do some people prefer Option 1 while
others do not?
Questions
2. If people can bring their own seafood to the
restaurant, do you think it is possible to have a
‘chef’ market in which the chefs are selfemployed to serve the customers, so that the
customers will bring their own seafood plus a
chef to the restaurant?
Questions
3.If people can bring their own seafood and
chefs to the restaurant, why not bring their
own tables, chairs, chopsticks, etc. ?
Past Paper Question
• “Whenever there is an employee, there is
firm.” Do you agree? Explain. (86, 10 marks)
Firms Supersedes Market
(Argument of Ronald Coase)
• There were costs of using the market
mechanism (the costs of discovering what
the relevant prices are).
• Costs:
(1) to discover the other party to deal with,
(2) to negotiate the terms of exchange,
(3) to draw up the contract,
(4) to enforce the contract.
Firms Supersedes Market
(Argument of Ronald Coase)
Without firms, there will be multilateral
contracts among individuals (buyers and
resource owners) and high transaction costs
incurred.
Firms Supersedes Market
(Argument of Ronald Coase)
• If the costs (of using market) are
prohibitively high, resources owners may
choose to work under the direction of a
visible hand (firm).
Why is using market costly?
(Elaboration by Steven Cheung)
1. Contracting cost - without firms, the
number of contracts is greater without firms.
Transactions Without Firms
(When there is one consumer)
Cloth maker
Consumer A
designer
cutter
sewer
Transactions Without Firms
(When there are 2 consumers)
Cloth maker
Consumer A
designer
cutter
Consumer B
sewer
Transactions Without Firms
(When there are 3 consumers)
Cloth maker
Consumer A
designer
Consumer C
cutter
Consumer B
sewer
Transactions Without Firms
(When there are 3 consumers)
12
product market
transactions
Transactions with
the Existence of a Firm
Cloth maker
Consumer A
designer
Consumer C
Firm
cutter
Consumer B
sewer
Transactions with
the Existence of a Firm
3 factor market transactions
4 product market transactions
• Factor market transactions 
• product market transactions 
• total no. of transactions 
Why is using market costly?
(Elaboration by Steven Cheung)
2. Information cost - consumers may have
high information cost to recognize the
different component parts of a product.
Why is using market costly?
(Elaboration by Steven Cheung)
3. Measurement cost - it is costly to measure
the characteristics or attributes of a
productive activity (e.g. a clerk)  a proxy
4. Cost of separating contributions (e.g.
teamwork)  a proxy on a take-it-or-leaveit basis
Firm Supersedes Market & the
Optimal Size of a Firm
• The use of firm can reduce the costs of
using the market mechanism.
“ Firm supersedes Market.”
Firm Supersedes Market & the
Optimal Size of a Firm
• If the use of the firm can reduce the cost of
using market, then
“Why don’t we have a super-firm to
organize all activities?”
Firm Supersedes Market & the
Optimal Size of a Firm
• Coase: When a firm expands, the
administrative costs (transaction
costs) increase.
• A firm will expand until at the margin, the
costs of organizing within a firm equal to:
(1) the cost of organizing in another firm;
(2) the cost of organizing through the market.
Communist State
• Can a communist state be regarded as a
super-firm?
Firm supersedes market.
Coase
The Nature of Supersession
• The use of firm can reduce the costs of
using the market mechanism.
“ Firm supersedes Market.” (R. Coase)
• Firm does not replace the market, instead it
separates a market transaction into two -factor market transaction vs. product market
transaction.
Past Paper Question
“When we pay a shoe-shine boy to shine a pair of
shoes for $10, the product market (the shine) and the
factor market (the boy’s labour) are not separate
markets and the firm does not exist.” Do you agree?
Explain your answer by using what you know about
the nature of the firm. (96, 8 marks)
Firm supersedes market.
Coase
Factor market supersedes product market.
Cheung
Firm  product market transaction 
 superseded by factor market transactions
Firm supersedes market.
Coase
Factor market supersedes product market.
Cheung
What is a firm?
?
It is futile to identify a “firm”, or say
anything about the size of the firm.
Under the piece-rate contract, a worker joins factory (a
firm), but is paid exactly according to the output he or
she produces (using the price mechanism). Hence, we
cannot say clearly whether the production is organized
by the firm or through the price mechanism.
Price
Firm supersedes market.
Coase
Factor market supersedes product market.
What is a firm?
Cheung
One type of contract supersedes another type.
Choice of organizational arrangements
Choice of contractual arrangements
Cheung
Questions
1. Why do contracts take the form observed?
2. What are the economic implications of
different contractual and pricing
arrangement?
Cheung
Choice of Contractual Arrangements
Cheung
Different Cases:
Taxi-driver
Teacher
Tennis player
Factory
worker
Film director
Salesperson
Waiter
Wage Contract
Teacher
A fixed amount paid to the factor owner on a specified time
period.
Benefit: As a proxy is paid, the pricing and measuring
contributions can be saved.
Cost: Workers tend to shirk and there will be high
monitoring cost.
Piece-rate contract
Factory
worker
Payment according to the amount of product produced.
Benefit: Workers have incentive to increase the output.
Cost: Workers pay less attention to the quality of output
Rental (fixed-rent)
contract
Taxi-driver
A fixed amount paid by a lessee to the factor owner.
Benefit: The lessee will work very hard to maximize the
residual income.
Cost: The depreciation rate and maintenance cost will be
higher; higher monitor the factor provided by other owners.
Share contract
Film director
An agreed proportion on output is shared between the parties
involved (e.g. employers and employees)
Benefit: Risk can be shared.
Cost: High costs to monitor inputs and to measure outputs.
Tips or gratitudes
Waiter
Commission
Salesperson
Prizes
Tennis player
Outright transfer
contract
Helicopter
Discussion
1. The employment of a teacher in a normal school,
in a tutorial school.
Time-rate contract for a teacher in a normal school.
Piece-rate contract for a teacher in a tutorial school.
2. A tourist guide
Time-rate contract plus tips
3. A salesman
Commission plus time-rate contract
96(17) 14. Drivers of franchised (green) mini-buses
are employed by mini-bus companies and are paid
at time rate. However, taxi-drivers pay a fixed rent
to taxi companies and take the residual income.
There is such a difference because
A. the cost of pricing of mini-bus services is lower.
B. it is less costly for the government to contract with
the mini-bus drivers.
C. the cost of monitoring mini-bus drivers is lower as
the buses have fixed schedules and routes.
D. it is costly to count the number of passengers taking
mini-buses.
Discussion
4. A film director.
Share contract
5. The royalties to a book author if
(a) the quantity of books sold is certain;
(b) the income of books sold is certain.
(a) A percentage royalty (share contract)
(b) A lump sum royalty
The End