ECON 4921: Lecture 3
Jon Fiva, 2009
Roadmap
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IIntroduction
t d ti
Institutions and Economic Performance
The Firm
Organized Interest and Ownership
Complementarity of Institutions
Institutions and Commitment
Agency problems: Voters- Politicians-Bureaucrats
Fiscal Federalism
System Competition
Coase 1937: The Nature of the Firm
• Wh
Why do
d nott allll economic
i transactions
t
ti
t k place
take
l
through market exchange?
• Why
Wh do
d we need
d firms?
fi
?
–
”What has to be explained is why one integrating force (the entrepreneur) should be
substituted for another integrating force (the price mechanism).” (p.398)
• Generally: impossible to conceive all possible
states of the world, and even if we could,
prohibitively costly to write complete contracts.
contracts
Æ incomplete employment contracts
Coase 1937: The Nature of the Firm
• Structure of the firm addresses the incentive
problems arising from incomplete contracts.
– Introduce authority relationship between employer
and employee
– Some aspects within authority of employer
• Compared to market: yields lower cost through
hierarchical command.
– Number of contracts reduced: series of contracts
substituted with one.
– General term contract, details decided upon later.
Putting-out system vs.
capitalist
i li factory
f
production
d i
1.
2.
3
3.
4.
Putting
g out system
y
((workshop)
p)
Complete contracts
Authority relation
Contingent renewal
The Putting out system
• aka workshop system
• A means of subcontracting work
– Highly decentralized
– Putter-out (P-O): Employer, works as coordinator
– Individual home workers (high skilled)
• Historically: in use up till 19th century
– E.g. textile, small arms, lock making
•
•
•
•
P-O supplies hirelings with materials
Price of finished product decided in advance
Workers choose work speed
No monitoring
General setup
• Workers with utility fn.
– w: wage
g
– e: effort
General setup
• Factory production in production unit
L: Employment per production unit (’firm’)
• Home production (in putting out-system):
• Case with team gains:
Putting out system
Putting-out
Decision making sequence:
1) P-O offers q (price)
2) Worker determines e (effort)
3) P-O
P O continues
i
relationship
l i
hi or goes to
another worker (search cost, b>0)
• P-O sells product for a given price =1
• Pay each worker:
• P-O surplus per worker:
• Home worker chooses e to max
ÆFOC:
Gives optimal effort response to incr. price:
. Assume SE
SE>IE
IE Æ
q, price per unit sold
For given q, how much effort are
yyou willing
g to p
provide?
Optimal e-response to q.
e
Adding indifference curves
q price per unit sold
q,
Remember:
Given e: increase q:
(i) increase pay.
pay
Given q: increase e:
(i) dislikes effort,
((ii)) effort Æ incr x Æ increase p
pay.
y
e(q) must cross each indiff.curve at bottom. Why?
e
q price per unit sold
q,
E(q)) start
E(
t t att same point
i t as
Why?
e
• P-O maximizes
ÆFOC:
Equilibrium:
• Tangency between isoprofit curve ( ) and
effort response curve of worker ( ).
D
C
•
Why mustt equil.
Wh
il be
b
characterized by
tangency between
isoprofit and e(q)?
Up>U0
• Workers better off employed by P-O than
p y
Why?
y
as unemployed.
– Let s* be average surplus per worker
– P-O
P O strategy:
• All workers are identical: s*=
– P-O cannot credible commit to quit
established relationship:
p s=
. New hirelings
g
are no better than current hirelings.
– Cannot squeeze to .
– To some extent locked in with hireling.
Equil Is not pareto-optimal
Equil.
pareto optimal
D
C
• Both would prefer to
move into
i t hatched
h t h d
area.
• Why isn’t this
combination of e,q
eq
reached?