Firm & Firm & ProductionProduction

Firm & Firm & ProductionProduction

EA Session 5: July 11EA Session 5: July 11thth, 2007, 2007Prof. Samar K. DattaProf. Samar K. Datta

Overview• Why does a firm exist?

– Decision to buy (subcontracting) or to make (internalization/ integration)

• Internal organization of the firm – Handling separation between ownership and control

• Technology & production function

• Classification of inputs & isoquants

• Production with one variable input (labor): Relation between AP & MP

• Production with two variable inputs & diminishing MRTS

• Returns to scale

• Some applications

Why does a firm exist?(not part of reading though)

• Answers provided by various economists– Coase (highlighting inside vs. market transaction)

• Choice of the least transaction-cost contractual arrangement to supply the commodity

– Negotiating with a representative of a coalition of resource owners (firm) for the complete commodity

– Negotiating with a large number of unitary firms for each component and assemblage of the commodity

– Alchian & Demsetz (shirking under team production)• Impossible to measure marginal product of each

member of the team• Creates incentive to shirk (reduce work effort without

proportional reduction in income) • To prevent shirking, members hire central agent to

monitor themselves• Monitor has low incentive to shirk as he gets a claim on

the firm’s residual income

Why does a firm exist? (not part of reading though)

– Barzel (highlighting measurability problem)• Environment characterized by costly information and outcomes

affected by chance• Due to decreasing returns from supervision, the one whose

contribution to common effort is the most difficult to measure will assume the role of entrepreneur

• Asymmetric information about entrepreneurial activity gives strategic advantage to entrepreneur

• Measurement problem solved by assigning entrepreneur a claim on the residual value of the joint venture.

– Williamson (highlighting role of specialized assets to conduct transactions – need to vest residual control and residual claim right on a single party)

• A specialized or custom-made product has asset specificity, which is vulnerable to opportunistic behavior by both buyers and sellers

• Ownership of specialized products or detailed long-term contracts are used to prevent problems of opportunistic bargaining

• Formalized structure of a firm is the specialized asset in this case• Therefore, the least transaction cost alternative is chosen

Why are capitalists the bosses?

• Who has got the maximum stake in the production process/system?

• With respect to whose efforts is there the maximum information failure problem?

• Which factor of production is a co-specialized asset along with the firm – land, labor, capital or the capitalist-entrepreneur?

Why does a firm exist?

– Two broad conditions, as cited by Dholakia & Oza:1. Q (x, y) ≥ Q (x) + Q (y), or, C (x, y) ≤ C (x) + C (y)

2. TC (x, y) ≤ TC (x) + TC (y)

Economies of scope thus working in terms of saving in • Either transformation costs (i.e., costs of inputs,

which enter directly into the production process)• Or transaction costs (i.e., costs of coordination &

monitoring of inputs directly entering into the production process)

Internal organization of the firm

• Unitary, partnership, or corporation• M (multi-divisional) form or U (unitary) form• How to manage separation between ownership

and control– Incentive-disincentive structure– Market for managers– Market for takeover

• Financing of the firm – debt/equity• Growth of the firm

– Organic (till marginal benefits, i.e. reduction in transaction costs, of internalizing an additional activity equal the marginal costs, i.e. increase of agency costs)

– Inorganic• Merger / Acquisition

– Vertical merger (value-addition through byproduct use)– Horizontal merger (economies of scope through co-

management of related products)

Possible objectives of the firm

1. Profit maximization2. Sales maximization3. Growth maximization4. Employment generation5. Satisficing behavior• In the long-run, no firm can ignore profit

considerations. Hence, profit maximization often looked upon as a reasonable description of firm behavior in reality.

The technology of production

• Production Process: Combining inputs or factors of production (land, labor, capital, organizational skill) to achieve an output, i.e., the transformation process

• Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs, given the state of technology.– Shows what is technically feasible when the

firm operates efficiently.

The Isoquant Map:Production with Two Variable Inputs

(L,K)

Labor per year

1

2

3

4

1 2 3 4 5

5

Q1 = 55

Isoquants showing all possible combinations of inputs that yield the same output

A

D

B

Q2 = 75

Q3 = 90

C

ECapitalper year

Importance of time period

• Short-run:– Period of time in which quantities of

one or more production factors cannot be changed.

– These inputs are called fixed inputs.

• Long-run:– All inputs are variable in the long run;

so there are no fixed inputs.

Production with One Variable Input (Labor): Relation between AP & MP

Laborper Month

Outputper

Month

60

112

0 2 3 4 5 6 7 8 9 101

A

B

C

D

8

10

20E

0 2 3 4 5 6 7 9 101

30

Outputper

Month

Laborper Month

AP = slope of line from origin to a point on TP, lines b, & c.MP = slope of a tangent to any point on the TP line, lines a & c.

• When the labor input is small, MP increases due to specialization (better utilization of fixed inputs).

• When the labor input is large, MP decreases due to inefficiencies (fixed factors become limited in supply).

Law of Diminishing Marginal Returns

Effect ofTechnological Improvement

Labor pertime period

Outputper time

period

50

100

0 2 3 4 5 6 7 8 9 101

A

O1

C

O3

O2

B

Labor productivitycan increase if there are improvements in

technology, even thoughany given production

process exhibitsdiminishing returns to

labor.

Marginal Rate ofTechnical Substitution

Labor per month

1

2

3

4

1 2 3 4 5

5Capital per year

Isoquants are downwardsloping and convex

like indifferencecurves, indicating declining MRS.

1

1

1

1

2

1

2/3

1/3

Q1 =55

Q2 =75

Q3 =90

Isoquants When Inputs are Perfectly Substitutable

Laborper month

Capitalper

month

Q1 Q2 Q3

A

B

C

Fixed-Proportions Production Function: Inputs are perfect

complements

Labor per month

Capitalper

month

L1

K1Q1

Q2

Q3

A

B

C

Increasing Returns to Scale

Labor (hours)

Capital(machine

hours)

10

20

30

Increasing Returns:The isoquants move closer together

5 10

2

4

0

A

Reasons:•Larger output associated with lower cost (autos)•One firm is more efficient than many (utilities)

Constant Returns to Scale

Labor (hours)

Capital(machine

hours)

Constant Returns:Isoquants are equally spaced because: • Size does not affect productivity• May have a large number of producers 10

20

30

155 10

2

4

0

A

6

Decreasing Returns to Scale

Labor (hours)

Capital(machine

hours)

Decreasing Returns:Isoquants get further apart due to:• Decreasing efficiency with large size• Reduction of entrepreneurial abilities10

20

30

5 10

2

4

0

A

Application: Malthus and the Food Crisis

• Why did Malthus’ prediction fail?

• Malthus did not take into consideration the potential impact of technology which has allowed the supply of food to grow faster than demand.

• Technology has created surpluses and driven the price down.

• Question: If food surpluses exist, why is there hunger?– The cost of distributing food from productive regions to

unproductive regions and the low income levels of the non-productive regions.

1) Growth in the stock of capital (both human and non-human) is the primary determinant of the growth in productivity.

2) Rate of capital accumulation in the U.S. was slower than other developed countries because the others were rebuilding after WWII.

3) Depletion of natural resources

4) Environmental regulations

Example: Explanations for Productivity Growth Slowdown

Co-existence of large & small units in the carpet

industry

• Economies of scale seem to be favoring larger units

• Advantages of product diversification as supported by market segmentation favoring smaller units