WEST
HILLS COLLEGE
ECONOMICS
CHAPTER 20
The Firm
In Chapter 20 we turn our attention from Demand and individual decision making to Supply. Chapters 20 and 21 discuss the nature of the firm and how producers make their decisions as to what to supply and at what price. First, we will learn who suppliers are and how they function. For that, Chapter 20 introduces us to the firm. We start learning about the theory of the firm as a productive “team,” and then we look at various types of businesses and the pros and cons of various types of business organizations. The chapter concludes with a look at the balance sheet of the typical firm and a discussion of how firms raise funds to support their activities.
CHAPTER OBJECTIVES
Upon completing this chapter, you should be able to:
1.Explain why firms exist.
2.Explain why shirking is a potential problem.
3.Discuss how the monitor (manager) solves the shirking problem.
4.Explain efficiency wage theory.
5.Identify the advantages and disadvantages of proprietorships, partnerships, and corporations.
6.Discuss how corporations finance their business activity.
I.WHY FIRMS EXIST—A business firm is an entity that employs factors of production and produces goods and services to be sold to consumers, other firms, and/or the government. People work for firms and we buy things from firms, Why do they exist?
A.The Market and the Firm: —The economy is made up of millions of individuals, all doing their own things. How do those individuals come together to make economic transactions and to produce things?
Prices guide market decisions and prices (including wages the price of labor) guides individuals into the activities at which they are most efficient and enables them to express their preferences for goods, instructing producers as to what is wanted and what is not.People working in groups allows for Division of Labor allows for more productive workers and therefore higher compensation
Managerial coordination guides and coordinates employees to perform work tasks.
firms are formed when the benefits that can be gained from working as a team are greater than the sum of the benefits that could be gained by acting individually.
1. Shirking in a Team—Team production also has disadvantages, the most significant of which is the problem of shirking—putting forth less than the agreed-to effort.
Shirking is a problem for businesses because the individual shirker gains all of the benefits of shirking, while the consequences of shirking are spread across the entire team.
2.The Monitor (Manager): Taking Care of Shirking—The monitor (manager) plays an important role in the firm.
In so doing, the monitor can preserve the benefits of team production while reducing, if not eliminating, the costs of shirking.
Because they share in the benefits of the others' work, but don't share in the cost.
What if the monitor plays favorites or pays low wages so as to raise his own wage?
One possibility is to make the monitor a residual claimant—a person who shares in the profits of the firm.
If the monitor shirks, then the monitor will suffer lost profits.
This sounds like a good idea but this is what went wrong with Enron. The managers lied company losses and said the company was profitable and then dipped into the companies funds to “reward themselves”.
There is a problem that has been identified by many analysts that managers are corrupted by pay tied to earnings.
It drives them to exagerate earnings or exagerate prospects- doing things that bring them personal gain but are not in th elong term interest of the company.
3.Can Above-Market Wages Cause People to Shirk Less?— It also raises a question. Do people always do more work, the more they are supervised?Some firms may pay above-market wages to discourage shirking and encourage employees to monitor themselves.The argument is that workers will not want to lose a job that pays them an above-market wage, and they will reduce shirking to ensure this.Monitoring costs fall more than wages go up. Thus firms save money by raising wages.This is known as the efficiency wage theory.
Thinking at the margin: If lowering supervision saves $1.00, will shirking rise by less than $1.00?
4.Markets: Outside and Inside the Firm—We can see why it’s efficient to have monitors, but that still doesn’t answer the question of why hard working workers would submit to such a relationship.
The answer may working a as a team first, it allows people to work more efficently and therefore allows higher pay and relatedly, it lowers transaction costs, and so allows higher pay.
C. The Objective of the Firm—What is the objective of the firm? Most economists will answer: profit maximization.
However, not all economists agree. Some such
as Baumol argue that firms try to maximize sales.
Still others argue that they will try to achieve a satisfactory level of profit and then pursue other goals. This is called satisficing behavior.
Others argue that managers try to maximize their own power and rewards, rather than the firm’s profits.
Much of this is a result of the separation of ownership from control: most businesses are owned and run by two different sets of people managerrs and stock holders.
Still, most economists feel that profit maximization is the driving force for most firms over time.
II.TYPES OF BUSINESS FIRMS—Business firms are organized in one of three basic ways:
A.Proprietorships—a form of business that is owned by one individual who makes all the business decisions, receives the entire profits, and is legally responsible for the debts of the firm.
As Exhibit 1 in the text shows, sole proprietorships make up the vast majority of business firms in the United States.
(1) they are easy to form and easy to dissolve, allowing for quick entry into and exit from a market;(2) all decision-making power rests with the sole proprietor, eliminating the need for group decision-making; and,
(3) since the profit of the proprietorship is the owner’s income, it is taxed only once.
(1) the sole proprietor faces unlimited liability—that is, the owner is responsible for all the debts of the proprietorship, and her personal property can be attached to settle those debts;(2) proprietorships often end with the death of their founder, creating a problem of sustainability; and(3) due to their size, liability problems, and lack of sustainability, proprietorships have a limited ability to raise funds for business expansion.
(1) a partnership is easy to organize;(2) partnerships work particularly well where team production involves skills that are difficult to monitor;(3) partnerships allow for the benefits of specialization; and(4) as with sole proprietorships, the profit of the partnership is the partners’ income, and only personal income taxes apply to it.
(1) the partners have unlimited liability, creating a particular problem when the debts for which you are liable are not your own;(2) decision-making can be complicated and frustrating; and(3) the loss of a partner, for whatever reason, can cause the partnership to be dissolved or restructured.
To deal with the problem of unlimited liability, most states allow the formation of limited partnerships, which allow the limited partners to limit their liability to the amount they have invested in the firm.
C. Corporations—a legal entity that can conduct business in its own name in the same way an individual does. Ownership of the corporation rests with stockholders who have limited liability in the debts of the corporation. As Exhibit 1 in the text shows, only 18.6 percent of all U.S. firms are corporations, but they account for almost 90 percent of all business revenues.
1. Advantages of Corporations—Corporations offer three distinct advantages over partnerships and sole proprietorships:
(1) the owners of the corporation (the stockholders) are not personally liable for the debts of the corporation—that is, they have limited liability, which assures that the stockholders can never lose more than the money they’ve invested in the corporation’s stock; They can not be sued for the corporations failure to pay debts.
(2) corporations continue to exist if one or more owners sell their shares or die; and
(3) due to their size, limited liability, and sustainability, corporations are usually able to raise large sums of capital for investment purposes.
2. Disadvantages of Corporations—Corporations
suffer from two distinct disadvantages:
(1) corporate profits are subject to double taxation—that is, they are taxed when the corporation earns them; then they are taxed again when they are distributed as dividends to the shareholders and become subject to the personal income tax;
Dividends A Share of the profits distributed to shareholders
(2) the separation of ownership from control can create disagreement between stockholders and management if their priorities are not the same. The text summarizes a dominant argument that the owners (the shareholders) don’t need to know what is going on in the corporation on a day-to-day basis. They need to follow the price and earnings reports.
The text also suggests that part of the problem of separation of ownership from control can be overcome by making the managers owners- giving them substantial amounts of stock.
Enron points to the fallacy of that argument.
Exhibit 3 in the text summarizes the advantages and disadvantages of proprietorships, partnerships, and corporations.
On the other hand, they go to the government for subsidies and tax breaks.
The text takes the position that the economy would be better off if the government ended corporate welfare, it is perfectly rational for corporations to seek out some corporate subsidies.
Hypocrisy or rationality? You decide.
III. THE BALANCE SHEET OF THE FIRM—All business firms have a balance sheet, which presents a picture of the financial status of the firm
B. Liabilities and Net Worth—The right-hand side of the balance sheet lists the values of the firm’s liabilities—the debts of the firm
—as well as the net worth (equity) the value of the firm to its owners. Assets minus liabilities.
Businesses have been revolutionized by computers. Word processing was a giant innovation. Networks have been revolutionary, but arguably the most revolutionary are computer spread sheets. Spread sheets the first “killer app”.
VisiCalc
IV. FINANCING CORPORATE ACTIVITY — Corporations have several options for raising financial capital.
While corporations (as well as partnerships and proprietorships) often borrow from banks and other lending institutions,
they have two other avenues that are unique: they can sell bonds (sometime referred to as issuing debt) and shares of stock.
2. Stock—a claim on the assets of the corporation that gives the purchaser a share of ownership of that corporation. Whereas the buyer of a bond is lending funds to the corporation, the buyer of stock is putting upmoney in exchange for a share of ownership and the right to share in the profits (and losses) of the corporation.
The owner of the company’s stock is rewarded with a share of the profits caleed a dividend or with a gain in the value of the company’s stock.
If the comopany goes broke the bond holders get paid and then if there is any money left, the stock holders get paid.
B. Nonprofit Firms—Not all firms are business firms. Put another way, not all firms are out to make a profit. Nonprofit firms are firms with no residual claimants. Any revenues that are earned in excess of costs must be plowed back into the operation of the firm or, perhaps, handed over to the state for example private colleges.
1. Incentives in Nonprofit Firms—It has been argued that the lack of profit, and residual claimants to reap that profit, eliminates the incentive to monitor shirking in nonprofit organizations.
Furthermore, since any excess revenues must be “reinvested” in the firm, rather than distributed among the owners, the top administrators of nonprofit organizations are expected to use those “excess” funds to improve the quality of life within the organization.
2. Types of Nonprofit Firms—Nonprofit firms can be either private or public.
Charitable organizations, such as the United Way, as well as churches, private colleges, etc., are examples of private nonprofit firms.
Tax-supported state universities, police forces, and public schools are examples of public nonprofit firms.
3. Funding and Control of Nonprofit Firms—Private nonprofit firms are funded by contributions from private citizens. As such, their activities are somewhat controlled by the need to attract funds and the ability of contributors to withhold funds to protest bad policies and/or shirking.
Public nonprofit firms are supported by taxpayers, The text takes the positio0n that taxpayers have who have very little to say about the uses of their taxes and have little recourse if they disagree with the policies or methods of public nonprofit firms.
The text is incorrect in this regard. In fact most public non-profit organizations are run by elected boards.
The text contains some very biased assertions about government and public policy.
4. Public Nonprofit Firms and Taxes—Private nonprofit firms use contributions as a source of funding for the firm’s operations.
If the quality of a nonprofit’s services declines, contributors might reduce their contributions until the services improve. These contributions are tax deductible.
Taxpayers who don’t like the policies of public
non-profit organizations may run for the board of the organizations to
redirect them.
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