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Coase, Theory of the Firm, Coase, Theory of the Firm, Tirole chapter 0Tirole chapter 0 Eric Rasmusen, erasmuse@Indiana.eduEric Rasmusen, erasmuse@Indiana.edu

G604, Tirole-Coasle, size of firms, march 28, 2006

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• Classics: OrganizationClassics: Organization         R. H. R. H. CoaseCoase (1937) (1937) "The Nature of the Firm,""The Nature of the Firm," Economica, Economica, New Series,New Series, 4, 16: 386-405 4, 16: 386-405 (November 1937) (November 1937)

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Coase (1937)Coase (1937)

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Transaction CostsTransaction Costs

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Using MarginalismUsing Marginalism

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Master and ServantMaster and Servant

• The last part of Coase is about The last part of Coase is about authority. The principal commands authority. The principal commands the agent. the agent.

• Why is the principal the entrepreneur Why is the principal the entrepreneur and not the worker? (not in Coase)and not the worker? (not in Coase)

• Why does the residual claimant have Why does the residual claimant have the authority? (not in Coase)the authority? (not in Coase)

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TiroleTirole

• Top person in theoretical IO, I’d say. Top person in theoretical IO, I’d say. He writes books a lot. Toulouse, MIT. He writes books a lot. Toulouse, MIT.

• p. 20. Why do economies of scale p. 20. Why do economies of scale have to be exploited have to be exploited withinwithin the firm? the firm?

• This relates to Coase (1937)This relates to Coase (1937)

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Why Not One Big Firm?Why Not One Big Firm?

Williamson’s Puzzle of Selective Intervention: Williamson’s Puzzle of Selective Intervention: why not merge two firms and then manage why not merge two firms and then manage them just the same as before? (p. 21)them just the same as before? (p. 21)

One answer: we cannot contract to make One answer: we cannot contract to make the CEO of each firm a residual claimant. the CEO of each firm a residual claimant.

Think of Holmstrom’s Teams model (1982). Think of Holmstrom’s Teams model (1982).

Rasmusen and Zenger, Rasmusen and Zenger, ``Diseconomies of Scale in ``Diseconomies of Scale in Employment Contracts,'' Employment Contracts,'' Journal of Law, Economics and Journal of Law, Economics and Organization Organization (June 1990), 6(1): 65-92 . (June 1990), 6(1): 65-92 .

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Bargaining Power Bargaining Power (Rasmusen)(Rasmusen)

Two possible meanings: Two possible meanings:

1. The threat point (Apex gets 2, Brydox 1. The threat point (Apex gets 2, Brydox gets 8) vs. (Apex gets 7, Brydox gets gets 8) vs. (Apex gets 7, Brydox gets 3) 3)

2. The division of surplus (Apex gets 2. The division of surplus (Apex gets 100%, Brydox gets 0%) vs. (Apex 100%, Brydox gets 0%) vs. (Apex gets 20%, Brydox gets 80%) gets 20%, Brydox gets 80%)

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Bargaining: Why the Coase Bargaining: Why the Coase Theorem Breaks Down (pp. 22-Theorem Breaks Down (pp. 22-

24)24)(2) Nature chooses buyer value v using density f(v) on [a,b] (2) Nature chooses buyer value v using density f(v) on [a,b]

with seller cost c in (a,b). The buyer observes this. with seller cost c in (a,b). The buyer observes this. (3) The seller offers price p to the buyer. (3) The seller offers price p to the buyer. (4) The buyer accepts or rejects. (4) The buyer accepts or rejects.

This leads to inefficiency–-the Myerson-Satterthwaite problem.This leads to inefficiency–-the Myerson-Satterthwaite problem.

Seller proposing an offer at (1) would not help. Seller proposing an offer at (1) would not help.

Merging at (1) Merging at (1) wouldwould help. So we should put buyer and seller in help. So we should put buyer and seller in the same firm.the same firm.

OR: give all the bargaining power to the informed party, e.g. OR: give all the bargaining power to the informed party, e.g. the contract at time (1) gives a lump sum X to the seller the contract at time (1) gives a lump sum X to the seller and gives the buyer the right to buy 0 or 1 unit at price and gives the buyer the right to buy 0 or 1 unit at price p=c (an option contract) OR use a fancy mechanism p=c (an option contract) OR use a fancy mechanism (footnote 29)(footnote 29)

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Asset Specificity/The Hold-Up Asset Specificity/The Hold-Up Problem (p. 24)Problem (p. 24)

(1) The buyer value is v=3. The seller can invest 2 to get c=0 (1) The buyer value is v=3. The seller can invest 2 to get c=0 or not invest, to keep c=4. or not invest, to keep c=4.

(2) The buyer offers price p to the seller. (or, use 50-50 split)(2) The buyer offers price p to the seller. (or, use 50-50 split)(3) The seller accepts or rejects. (3) The seller accepts or rejects.

This leads to investment of 0. This leads to investment of 0.

The buyer proposing an offer at (0) *would* help. The buyer proposing an offer at (0) *would* help.

Merging at (0) would help too. So we should put buyer and Merging at (0) would help too. So we should put buyer and seller in the same firm.seller in the same firm.

OR: give all the bargaining power to the investing party, i.e. OR: give all the bargaining power to the investing party, i.e. the seller here. the seller here.

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Asset Specificity/The Hold-Up Asset Specificity/The Hold-Up Problem Example (p. 28)Problem Example (p. 28)

Joskow found that when coal quality is Joskow found that when coal quality is diverse, not many transportation diverse, not many transportation methods, and few mines, then methods, and few mines, then long-term contracts will be used long-term contracts will be used (West US)(West US)

In the opposite case, short-term In the opposite case, short-term contracts (spot markets) are used contracts (spot markets) are used (East US)(East US)

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Authority (p. 30)Authority (p. 30)

• Authority changes the threat point in Authority changes the threat point in bargaining. It changes, in a sense, bargaining. It changes, in a sense, bargaining power. bargaining power.

• Think of the UN Security Council. Think of the UN Security Council. Suppose Russia and France do not care Suppose Russia and France do not care about Rwanda policy, but the US does. about Rwanda policy, but the US does. Is the effect of giving them veto power Is the effect of giving them veto power over US policy to change US policy? over US policy to change US policy?

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Unconstrained Bargaining (pp. Unconstrained Bargaining (pp. 31-32)31-32)

(0) The buyer and seller have made a basic contract.(0) The buyer and seller have made a basic contract.(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new

feature that will cost the seller c to produce. feature that will cost the seller c to produce. (2) The buyer value of the new feature is v>c with (2) The buyer value of the new feature is v>c with

probability x and 0 otherwise.probability x and 0 otherwise.(3) Buyer and seller bargain for a price p for (3) Buyer and seller bargain for a price p for

the feature. If they disagree, the new the feature. If they disagree, the new feature is not added to the product.feature is not added to the product.

Assume: bargaining splits the gains from agreement. Assume: bargaining splits the gains from agreement.

Result: UnderinvestmentResult: Underinvestment

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Seller Has Authority to Make Seller Has Authority to Make Changes ( p. 32)Changes ( p. 32)

(0) The buyer and seller have made a basic contract.(0) The buyer and seller have made a basic contract.(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new

feature that will cost the seller c to produce. feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with (2)The buyer value of the new feature is v>c with

probability x and 0 otherwise.probability x and 0 otherwise.(2.5) The seller decides whether to add the (2.5) The seller decides whether to add the

new feature to the product. new feature to the product. (3) Buyer and seller bargain for a price p for (3) Buyer and seller bargain for a price p for

the feature. The feature is added only if the the feature. The feature is added only if the seller agrees to add it.seller agrees to add it.

Assume: bargaining splits the gains from Assume: bargaining splits the gains from agreement. agreement.

Result: UnderinvestmentResult: Underinvestment

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Buyer Has Authority to Make Buyer Has Authority to Make Changes ( pp. 32-33)Changes ( pp. 32-33)

(0) The buyer and seller have made a basic contract.(0) The buyer and seller have made a basic contract.(1) The buyer invests I=x^2/2 in researching a new (1) The buyer invests I=x^2/2 in researching a new

feature that will cost the seller c to produce. feature that will cost the seller c to produce. (2)The buyer value of the new feature is v>c with (2)The buyer value of the new feature is v>c with

probability x and 0 otherwise.probability x and 0 otherwise.(2.5) The buyer decides whether to add the new (2.5) The buyer decides whether to add the new

feature to the product. feature to the product. (3) Buyer and seller bargain over whether the (3) Buyer and seller bargain over whether the

new feature is to be added. The decision is new feature is to be added. The decision is ultimately up to the buyer. ultimately up to the buyer.

Assume: bargaining splits the gains from agreement.Assume: bargaining splits the gains from agreement.Result: OverinvestmentResult: Overinvestment

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What if the New Feature Might What if the New Feature Might Be Actually a Negative?Be Actually a Negative?

• We can run that model with probability We can run that model with probability x of value v>c and probability (1-x) of x of value v>c and probability (1-x) of value –y<0 too. Then, buyer authority value –y<0 too. Then, buyer authority does not result in overinvestment, I does not result in overinvestment, I think--- for reasons elucidated in Lyon think--- for reasons elucidated in Lyon and Rasmusen, and Rasmusen, “Buyer-Option Contracts, Renegotiation“Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem,'‘ , and the Hold-Up Problem,'‘ Journal of Law, Economics and Journal of Law, Economics and OrganizationOrganization, 20,1: 148-169 (April , 20,1: 148-169 (April 2004)2004)

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A link to the course websiteA link to the course website

http://www.rasmusen.org/g604/0.g604.http://www.rasmusen.org/g604/0.g604.htmhtm