Nature of the Firm Pt.3

The Nature of the Firm

Defining Characteristic

• Production is directed by price movements coordinated through market exchange transactions outside the firm
• Market transactions are eliminated within a firm
• The entrepreneur-coordinator substitutes complicated market structure with exchange transactions, directing production within.
• Coordinating production can happen through these alternative methods
• A firm's distinguishing mark is the supersession of the price mechanism

Reasons for Firms

• There is a cost associated with using the price mechanism
• The most obvious cost of organizing production through the price mechanism is discovering the relevant prices
• Negotiating and concluding separate contracts for each market transaction incurs costs
• Dahlman (1979) identified transaction costs, including search and information costs
• Bargaining and decision-making also contribute to transaction costs.
• Monitoring and enforcement costs are transaction cost types
• Mechanisms exist that reduce costs, but they do not disappear
• Firms emerge when short-term contracts are unsatisfactory
• A firm consists of relationships that come into existence when an entrepreneur directs resources

Factors Determining Firm Size

• Marginal cost of organizing/managing increases with the number of transactions
• A firm reaches its limit when the marginal cost of organization equals the marginal cost of using the market
• Firm transaction costs depend on transaction geography and communication costs
• Firm transaction costs depend on the (dis-)similarity of transactions
• Firm transaction costs depend on the probability of price changes

Williamson's Puzzle

Key incentive

• One key incentive for vertical integration stems from the risk of ex-post opportunism involving specific investments (Williamson, 1975)
• In a merger, individual incentives within a firm change, which is a problem
• Owners of integrated firms have different incentives compared to owners of non-integrated firms, as do managers
• Strong market incentives cannot be reproduced within a firm

Influence Costs

• Influence costs exist within a firm (Milgrom/Roberts, 1990)
• There is a tendency to intervene too often from above.
• Time is used for influencing activities, also know as "office politics"
• Inefficient decision proceedings can occur due to information losses.
• Resources can be used to lower influence costs

Ownership and Control

Principal-Agent Problems

• Separation of owners and managers results in principal-agent problems
• Capital markets offer a solution

Capital Markets

• Manne (1965) argues inefficient firm control/supervision can lead to a takeover
• The mere threat of a takeover can discipline management
• Jensen/Meckling (1976) say that a firm’s capital structure minimizes agency costs related to debt-equity ratio
• Equity financing increases owner monitoring but may reduce management performance incentives
• Debt financing increases the incentives to invest in risky projects. because the potential loss to owners and managers is limited in case of bankruptcy

Labor Market

• The labor Market disciplines managers who mismanage a firm, as they may have difficulty finding new jobs (Fama, 1980)

Internal Incentive Schemes

• Internal schemes uses incentive contracts such as stock options, bonuses, etc.

Product Market

• Inefficient firms, that cannot pass high costs to consumers, are eliminated by competitive product markets (Hart, 1983; Holmstrom & Tirole, 1989)