PHL295 Final Exam study notes
1. Gauthier claims that „market outcomes are neither right nor wrong‟.
In a market we are on our own and naturally produce the outcome. The outcome
of the market is neither morally right nor morally wrong, because the coincidence
of equilibrium and optimum (morality presents a solution to the problem of sub-
optimality) under conditions of free interaction removes both need and rationale
for the constraints that morality provides, and that enable us to distinguish
situations as right or wrong. A market immunizes you from collective action
problems and therefore there is no need for morality. Morality is an artificial way
of bringing about what occurs naturally in optimal market interactions. The
market creates a circumstance where people pursuing their self-interests do not
produce any collective action problems. It is not that the market is moral or
immoral; it is that it is above and beyond morality because it solves sub-optimal
interactions and creates optimal interactions.
2. What are externalities, and how does their presence affect the workings of
the invisible hand?
Private property are internalized externalities, Gauthier says that the first step to
solving collective action problems is a regime a private property. Collective
action problems arise from people imposing externalities on you, and property
internalizes and gets rid of externalities. Absence of externalities is a condition for
perfect competition. Externalities occur when an exchange or consumption affects
someone uninvolved who is not willingly a part of it (could be beneficial or
harmful). Essential to the operation of the perfectly competitive market is the
marginal matching of supply and demand. Externalities upset this matching.
Individual endowments and private goods, free market activity and mutual
unconcern, and the absence of externalities are the characteristics of the perfectly
competitive market. Each individual can expect a return equal to his or her
contribution. The absence of externalities ensures that no one is affected by any
market activity to which she or he has not chosen to be a part of. The presence of
externalities breaks the link between equilibrium and optimum demanded by
3. Coase claims that corporations are like islands of conscious power in an
ocean of unconscious cooperation. Explain.
Islands of conscious power: morality
Unconscious cooperation: we do not need to be aware in the market
The firm is a way of organizing economic transactions without a price
Corporations require morality because there involves a hierarchy, whereas
corporations exist in the market which does not require morality and uses a price
mechanism to create unconscious cooperation. People do not act purely out of
self-interest in a corporation (unlike the market) which allows them to function
Why corporations? Transaction costs that occur in the market because trade cannot automatically be carried out – trade is a system of cooperation that is
extremely vulnerable to fraud.
4. Why is the price mechanism „superseded‟ within the firm?
The price mechanism (considered purely from the side of the direction of
resources) might be superseded if the relationship, which replaced it, was
desired for its own sake. This would be the case, for example, if some people
preferred to work under the direction of some other person (hierarchy instead of
exchange). We unconsciously cooperate in the market because of the price
mechanism, but there is no need for this within the corporation.
5. What is a transaction cost?
A cost incurred in an economic exchange, the market is not free to use
It would be extremely costly for us to engage in multiple private contracts, we are
better off using corporations. There is always a cost to getting people to
cooperate. Competition and trade both have costs in the market, they do not just
There is a distinction between market transaction costs and administered
transaction costs – both are costly and have invisible costs (things that do not
happen in the market because of things people are worried will happen).
Administered transaction costs will often be different from market transaction
costs. What is crucial is that they are different and whichever one is cheaper
dictates where the cost will occur.
6. According to Miller, what are the three primary causes of market failure?
Why is a hierarchy sometimes better than a market?
3 Causes of Market Failure:
i) Information asymmetries – one side is deprived of vital information while it is
available to another side
ii) Monopoly power – there needs to be market competition, a competitive market
entails that no single buyer or seller can have an impact on the equilibrium market
price by withholding her sale or purchase (if they can do this then they have
acquired a monopoly power)
iii) Externalities – the transactions in the marketplace cannot have an impact on
third parties. Whether the externality is good or bad, a normal economic buyer
will not consider the externality in purchasing the good.
(Problems of information asymmetries make the costs of market transactions even
The reason why hierarchical organizations (corporations) are able to out
perform the market is because they encourage people to act cooperatively and
not out of self-interest (sports team example – you work together to beat the other
team and no strictly in our own self interests). People do not act purely out of self-
interest in corporations which allows them to function better.
7. What is a collective action problem, or a prisoner‟s dilemma?
A collective action problem occurs when people engage in costly behavior
because they do not need to bear the costs. A temptation to free ride is generated.
Restaurant group example: everyone goes out to eat and drink and you’re all
expected to split the bill evenly
Offensive deflection: you don’t want to order an expensive drink because everyone else will bear the costs
Defensive deflection: other people are ordering expensive things so you do the
Whenever you’re collectivizing a cost, people lose incentive to minimize that cost
Prisoner’s dilemma: Two men are arrested, but the police do not have enough
information for a conviction. The police separate the two men, and offer both the
same deal: if one testifies against his partner (defects/betrays), and the other
remains silent (cooperates with/assists his partner), the betrayer goes free and the
one that remains silent gets a one-year sentence. If both remain silent, both are
sentenced to only one month in jail on a minor charge. If each 'rats out' the other,
each receives a three-month sentence. Each prisoner must choose either to betray
or remain silent; the decision of each is kept secret from his partner until the
sentence is announced. Provides an example of when two parties might not
cooperate even though it appears to be in their best interests.
8. What are the 5 „core structural characteristics‟ of a corporation according to
Hansmann & Kraakman?
1) Legal personality: a contracting party distinct from the various individuals who
own or manage the firm, or are suppliers or customers of the firm. Provides the
firm with the ability to own assets that are distinct from the property of other
2) Limited liability: the liability of a firm’s owners for no more than the capital
they have invested in the firm – limited liability permits flexibility in the
allocation of risk and return between equity holders and debt holders
Separation between personal assets of owners and assets of the company
3) Transferable shares: transferability (does not entail fully tradeable) permits the
firm to conduct business uninterruptedly as the identity of its owner changes, thus
avoiding the complications of member withdrawal that are common among
partnerships, cooperatives, and mutuals
4) Centralized management under a board structure: delegation permits the
centralization of management necessary to coordinate productive activity,
delegation of decision making power to specific individuals notifies third parties
as to who in the firm has the authority to make binding agreements.
5) Shared ownership by contributors of capital (investor ownership): ownership
used in this sense with the right to control the firm, and the right to receive the
firm’s net earnings. Investor owned firms entail a firm in which both elements of
ownership and are tied to investment of capital in the firm.
9. What is the principle difference between shareholders and creditors?
A shareholder can participate in the earnings of the company through dividends
and capital gains; a creditor has not participation in the profits. The only money
earned back to the creditor is their initial investment, whereas shareholders have
the potential gain more money back when the company profits. If a company goes
under, the creditor is given priority to getting their money back whereas the
shareholder only gets money back if there is enough after settling all other
accounts. Being a shareholder is much more risky but could have a much bigger
pay off if the company does well. 10. Why does Friedman say that the claim that businesses have „social
responsibilities‟ is a „fundamentally subversive (traitorous/destabilizing)
doctrine‟ in a free society?
Friedman believes that there is one and only one social responsibility of business
– to use its resources and engage in activities designed to increase its profits so
long as it stays within the rules of the game, meaning that it engages in open and
free competition without deception or fraud.
The doctrine of ‘social responsibility’ taken seriously would extend the scope of
the political mechanism to every human activity. It does not differ in philosophy
from the most explicitly collectivist (subscribing to the socialistic doctrine of
ownership by the people collectively) doctrine. It differs only by professing to
believe that collectivist ends can be attained without collectivist means.
11. What are the constraints that Freidman acknowledges upon the pursuit of
The constraints Friedman acknowledges upon a firm’s pursuit of profit are that it
must stay within the rules of the game, which is to say, that it engages in open
and free competition without deception or fraud.
12. Easterbrook and Fischel ask why corporate law should not be abolished
entirely, “and let people negotiate wherever contracts they please.” What is
their answer to this question?
The short but not entirely satisfactory answer is that corporate law is a set of
terms available off-the-rack so that participants in corporate ventures can save
the cost of contracting. Corporate law – and in particular the fiduciary principle
enforced by the courts – fills in the blanks and oversights with the terms that
people would have bargained for had they anticipated the problems and been able
to transact costlessly in advance. Corporate law supplements but never displaces
13. In Hansmann‟s view, what are the two characteristics that „owners‟ of a firm
A firm’s owners are those persons who share two formal rights: the right to
control the firm and the right to appropriate the firm’s profits, or residual
earnings (net earnings that remain with the firm after it has made all payments to
which it is contractually committed). Residual claim + formal control = you’re
14. For Hansmann, what are some of the factors that determine which „patron‟
group will become the owner of a firm?
4 patrons of the firm: suppliers, investors, customers, and workers
It tends to be the owners that assume the most risk, the owner is whoever is
willing to invest the most money in the firm, this is usually the investors that
provide the capital for the firm (shareholders). The right to exercise discretion in
contracts is a vital component of control over the firm, and is by definition the
prerogative of the firm’s owners. The firm may itself also own assets, outright, of
course, in which case the exercise of discretion over the use of those assets is
included among the control of rights belonging to the owners of the firm. When
the relationship is one of ownership, the patron has the additional (additional to
controlling the firm’s behavior by seeking enforcement of his contract with the firm, or threatening to cease interacting with the firm in favor of whatever better
option the market offer him) option of seeking to control the firm’s behavior
directly through the firm’s mechanisms for internal governance.
15. Boatright argues that “the interests of non-shareholder constituencies are
best protected by a variety of safeguards that are unrelated to the right of
control”. Explain what this means.
Control for shareholders is the most suitable protection for their firm-specific
The right of control is of little value to other input providers or stakeholder
groups because their return is secure as long as a firm is solvent (has enough
money), not maximally profitable. In addition, the return on the firm-specific
contribution of other, non-shareholder groups are better protected by other means.