The Nature of the Firm

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The Nature of the Firm
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In Classical economics
MARKET
Market is an efficient mechanism in allocation
resources from low-valued uses to high-valued
uses. At equilibrium, MUV MC.
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In reality
Consumer A Consumer B Consumer C
Firm employs various factors of production for
turning out goods to be sold to final consumers.
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The nature of the firmB. Why does firm
exist?C. The contractual nature of the firm
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A. What is the nature of the firm?

• As a mechanism of allocating resources for
  production
• Within a firm, factor owners respond to the
  authority and direction of entrepreneur instead
  of the market signals
• Visible hand replaces invisible hand in directing
  the use of resources

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A. What is the nature of the firm?

• Factor market transactions supersede product
  market transactions
• The no. of factor market transaction increases
  while that of product market transaction
  decreases
• It is a marginal substitution, not an all-or-none
  substitution

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A. What is the nature of the firm?

• Factor owners voluntarily surrender the autonomy
  of their factors to the entrepreneur in exchange
  for an income
• Such income, measured by time, does not
  accurately measure the contribution of an
  individual factor to the total revenue
• It is called as a proxy payment

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B. Why does firm exist?

• Firm emerges as an alternate device for
  coordinating factor allocation because there are
  huge costs of using market, like
• The cost of discovering relevant prices
• The cost of knowing the product
• The cost of negotiating and enforcing separate
  contracts
• The cost of measuring marginal contribution of
  each factor owner

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B. Why does firm exist?

• The existence of firm saves greatly the
  transaction costs of using product market
• Why dont we have only a big firm on earth so
  that we can keep the transaction costs of using
  product market at minimum?
• It is because there are also transaction costs of
  using firm / factor market

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B. Why does firm exist?

• The transaction costs of using firm, like
• The cost in setting up a legal framework
• The cost of hiring monitors and supervisors to
  reduce shirking among factor owners
• The cost of assigning tasks among factor owners
  to meet changed circumstances

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B. Why does firm exist?

• The optimum firm size could be found when the
  savings in market transaction costs equate the
  monitoring costs of using firm at the margin, and
  the monitoring costs of each firm are the same

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C. The contractual nature of the firm

• To Professor Coase, in a firm, the entrepreneur
  holds a set of use rights of the factors and
  coordinate production activities without
  immediate reference to the price in market
• To Professor Cheung, there is no such thing as a
  firm in reality

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C. The contractual nature of the firm

• When you pay 20 to a shoe-shinning boy who
  brushes your shoes, is this a product market
  transaction or a factor market transaction?
• Do you pay for the product of a pair of brushed
  shinning shoes?
• Do you pay for the factors, like labour and
  shoe-cream, which make your shoes shine?

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C. The contractual nature of the firm

• Prof. Cheung argues that the payment is either
  for the product or for the factor
• It is redundant to speak of a product market and
  a factor market
• In the absence of a firm, product market and
  factor market are not separate market
• There is no supersession between factor market
  and product market
• There is only one market and no firm

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C. The contractual nature of the firm

• Prof. Cheung emphasizes the contractual nature of
  the supersession
• Why would a factor owner sign a contract with an
  enterpreneur but not with a final consumer?
• The natures of these two types of contract are
  exactly the same, but they have the same nature

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C. The contractual nature of the firm

• In a contract, the rights and responsibilities of
  both buyer and seller would be confined
• The buyer could be a consumer or an entrepreneur
• The seller could be a producer or factor owner

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C. The contractual nature of the firm

• When a developing company contracts out a project
  to a construction company, are there two firms or
  one firm?

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C. The contractual nature of the firm

• If Firm A directs the production activities of
  Firm B, could we say that the entrepreneur of
  Firm A manages the factor owners work in Firm B?
• If this is so, in economics point of view, there
  could be one firm
• Then there is only one big FIRM in the world, as
  all firms have such contractual relationship

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C. The contractual nature of the firm

• In China, many boats were pulled upstream with a
  rope by team of men (or boat hands ??) walking on
  shore

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C. The contractual nature of the firm

• These boat hands were supervised by a leader who
  would beat those who are lazy
• Who is employer? Who is employee?
• The workers employ the leader to supervise them
• There is cooperation among enterpreneur and
  factor owners

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C. The contractual nature of the firm

• In reality, there are many types of contractual
  arrangements, like
• Fixed wage rate contract (e.g. office clerk)
• Piece rate contract (e.g. garment worker)
• Commission (e.g. salesman)
• Fixed rental contracts (e.g. taxi drivers)
• Self-employed (e.g. insurance agents)

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C. The contractual nature of the firm

• The choice of different types of contracts
  depends on the nature of each transaction and
  product. Prof. Cheung singled out the
  significance of the cost of discovering relevant
  prices (one type of the transaction costs) and
  the concept of risk aversion to explain the
  choice of a particular contract.
• In short, the choice of contractual arrangement
  is made on the basis of the minimization of
  transaction costs and the sharing of risk.
• Recently, he considers that the explanation in
  terms of transaction costs is more useful, as it
  is difficult to measure risk.