Nature of the Firm Pt.2

The Nature of the Firm

• The defining characteristic of a firm involves the supersession of the price mechanism.
• Outside a firm, price movements coordinate production through market transactions.
• Within a firm, market transactions are eliminated, and an entrepreneur-coordinator directs production.

Why Firms Exist

• There is a cost associated with using the price mechanism.
• Discovering relevant prices is the most obvious cost of organizing production via the price mechanism.
• Costs exist for negotiating and concluding separate contracts for each market transaction.
• Dahlman (1979) identified transaction costs include search and information costs, bargaining and decision-making costs, and monitoring and enforcement costs.
• Mechanisms exist to reduce transaction costs, however they do not disappear completely.
• Firms emerge when short-term contracts are unsatisfactory.
• A firm consists of relationships where resource direction depends on an entrepreneur.

Determinants of Firm Size

• Organizing can eliminate certain costs and reduce production costs.
• The marginal cost of organizing or managing increases as the number of transactions increase.
• The limit of the firm is reached when the marginal cost of organization equals the marginal cost of using the market.
• Firm transaction costs depend on the geography of transactions, the similarity of transactions, and the probability of price changes.

Williamson's Puzzle

• Williamson (1975) stated one key incentive for vertical integration results from the risk of ex-post opportunism with specific investments.
• The puzzle explores why large firms struggle to replicate the success of multiple small firms.
• Incentives change within a merged firm, influencing individual motivation.
• Integrated firm owners and managers possess different incentives compared to those in non-integrated firms.
• The strong incentives provided by the market cannot be easily reproduced within a firm.
• Mergers have about a 50:50 success/failure rate in practice.
• Influence costs exist within a firm (Milgrom/Roberts, 1990).
• Influence costs include the tendency to intervene too often from above, time used for influencing activities, inefficient decision proceedings, and resources used to lower influence costs.

Ownership and Control

• The separation of owners and managers in a firm results in principal-agent problems.
• Capital markets function to take over if a firm’s control/supervision is inefficient, which then disciplines management (Manne, 1965).
• Jensen/Meckling (1976) suggests a firm’s capital structure can be explained by the motive to minimize agency costs, where debt and equity are associated with different agency costs based on the debt-equity ratio.
• Equity financing increases owner monitoring but may reduce management performance incentives.
• Debt financing increases incentives to invest in risky projects, because the potential loss for owners and managers is limited in bankruptcy.
• Fama (1980) suggests the labor market serves as a disciplining device; managers that mismanage, do not find new jobs.
• Internal incentive schemes, like stock options and bonuses, are used.
• Hart (1983) and Holmstrom & Tirole (1989) say inefficient firms are sorted out by the product market. If product markets are competitve, firms cannot pass their high costs on to consumers.