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Social Science
SOSC 4043
Sonya Scott

SOSC 4043 – FALL TERM BOOK NOTES September 17 , 2013 The Nature of the Firm (By: R.H. Coase) - Economic theory has suffered in the past from a failure to state clearly its assumptions, omitting the examination of the foundations on which it was created, which are necessary to prevent misunderstanding - Two questions to be asked of a set of assumptions in economics: o 1) are they tractable? o 2) do they correspond with the real world? - Theme of paper: show that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall – the idea of the margin and that of substitution - Description of the economic system given by Sir Arthur Salter: the normal economic system works itself o Its current operation is under no central control o Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive - This theory assumes that this direction of resources is dependent directly on the price mechanism - Salter’s description is incomplete picture when you think within a firm - In economic theory, allocation of factors of production between different uses is determined by the price mechanism - Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market - Within a firm, these market transactions are eliminated and in place of the completed market structure with exchange transactions is substituted the entrepreneur-co-oridinator, who directs production - Co-ordination of the various factors of production is normally carried out without the intervention of the price mechanism - The distinguishing mark of the firm is the supersession of the price mechanism - Distinction between allocation of resources in a firm and the allocation in the economy system described when discussing Adam Smith’s conception of the capitalist: o “something more important than the relations inside each factory or unit captained by an undertaker; there were the relations of the undertaker with the rest of the economic world outside his immediate sphere . . . . the undertaker busies himself with the division of labour inside each firm and he plans and organises consciously o Here he plays his part as a single cell in a larger organism, unconscious of the wider role he fills - Purpose of paper: bridge gap in economic theory between assumption that resources are allocated by means of the price mechanism and the assumption that this allocation is dependent on the entrepreneur-co-ordinator - If the desire was not to be controller but to control, to exercise power over others, then people might be willing to give up something in order to direct others; they would be willing to pay others more than they could get under the price mechanism o Implies those who direct pay are not paid to direct, which is not true in majority of cases - The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism - The most obvious cost of “organising” production through the price mechanism is that of discovering what the relevant prices are - Contracts are not eliminated when there is a firm but they are greatly reduced - The contract is one whereby the factor, for a certain remuneration, agrees to obey the directions of an entrepreneur within certain limits - There are disadvantages of using the price mechanism o It may be desired to make a long-term contract for the supply of some article or service, but owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible and less desirable it is for the person purchasing to specify what the other contracting party is expected to do - The operation of a market costs something and by forming an organisation and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved o Has to carry out function at less cost - It seems improbable that a firm would emerge without the existence of uncertainty - Exchange transactions on a market and the same transactions organised within a firm are often treated differently by governments or other bodies with regulatory powers - A firm consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur o Firm becomes larger as additional transactions are organised by entrepreneur and smaller as he abandons the organisation of such transactions - The possibility of monopoly gains offers a powerful incentive to continuous and unlimited expansion of the firm, which force must be offset by some equally powerful one making for decreased efficiency with growth in size, if even boundary competition is to exist - Reasons for why all production is not carried on by one big firm: o As the firm gets larger, there may be decreasing returns to the entrepreneur function – costs of organising additional transactions may rise o As the transactions which are organised increase, the entrepreneur fails to place the factors of production in the uses where their value is the greatest o The supply price of one or more of the factors of production may rise because the other advantages of a small firm are greater than those of a large firm - A firm will tend to expand until the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm - A firm will tend to be larger: o A) the less the cost of organising and the slower these costs rise with an increase in the transactions organised o B) the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised o C) the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size - Inventions which tend to bring factors of production nearer together, by lessening spatial distribution, tend to increase the size of the firm - All changes which improve managerial technique will tend to increase the size of the firm - There is a combination when transactions which were previously organised by two or more entrepreneurs become organised by one - This becomes integration when it involves the organisation of transactions which were previously carried out between the entrepreneurs on a market - The integrated force in a differentiated economy already exists in the form of the price mechanism o It is perhaps the main achievement of economic science that it has shown that there is no reason to suppose that specialisation must lead to chaos - What has to be explained is why one integrating force (the entrepreneur) should be substituted for another integrating force (the price mechanism) - Professor Knight: o “with the introduction of uncertainty – the fact of ignorance and the necessity of acting upon opinion rather than knowledge is entirely changed . . . . with uncertainty present doing things, the actual execution of activity, becomes in a real sense a secondary part of life ; the primary problem or function is deciding what to do and how to do it/” - The fact of uncertainty brings about the two most important characteristics of social organisation o 1) good are produced for a market, on the basis of entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers’ wants o 2) the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur . . . . When uncertainty is present and the task of deciding what to do and how to do it takes the ascendancy over that of execution, the internal organisation of the productive groups is no longer a matter of indifference or a mechanical detail - “with human nature as we know it, it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter’s actions without being given power to direct his work o On the other hand, the second party would not place himself under the direction of the first without such a guarantee - The result of this manifold specialisation of function is the enterprise and wage system of industry o Its existence in the world is the direct result of the fact of uncertainty - Fact of uncertainty means people have to forecast future wants. Therefore, you get a special class springing up who direct the activities of others to whom they give guaranteed wages - Professor Knight open to criticism on several grounds: o Points out that certain people have better judgment or better knowledge does not mean that they can only get an income from it by themselves actively taking part in production  It is possible to give a guaranteed reward providing that certain acts are performed without directing the performance of those acts o Points out that it is unusual for one man to guarantee to another a definite result without being given power to direct his work  Large proportion of jobs are done where the contractor is guaranteed a certain sum providing he performs certain acts, but this does not involve any direction o Gives no reason why the price mechanism should be superseded - Under perfect competition, since everything that is produced can be sold at the prevailing price, then there is no need for any other product to be produced o This argument ignores the fact that there may be a point where it is less costly to organise the exchange transactions of a new product than to organise further exchange transactions of the old product - The cost curve turns upwards does not give a limitation to the size of the firm - To determine the size of the firm, we have to consider the marketing costs (the costs of using the price mechanism), and the costs of organising of different entrepreneurs and then we can determine how many products will be produced by each firm and how much of each it will produce - Legal relationship called “master and servant” or “employer and employee” o A) servant must be under the duty of rendering personal services to the master or to others on behalf of the master, otherwise the contract is a contract for sale of goods or the like o B) the master must have the right to control the servant’s work, either personally or by another servant or agent. It is this right of control or interference which is the dominant characteristic in this relation and marks off the servant from an independent contractor, or from one employed merely to give to his employer the fruits of his labour. In the latter case, the contractor or performer is not under the employer’s control in doing the work or effecting the service; he has to shape and manage his work so as to give the result he has contracted to effect. - Professor Batt: o “that which distinguishes an agent from a servant is not the absence or presence of a fixed wage or the payment only of commission on business done, but rather the freedom with which an agent may carry out his employment.” - Initiative means forecasting an operates through the price mechanism by the making of new contracts - Management proper merely reacts to price changes, rearranging the factors of production under its control The Financial Theory of the Firm (By: Wayne Norman) What Kind of Theory is the “Theory of the Firm”? - Firms or corporations are social constructions and human institutions, and they are creatures of the law: o You cannot be a corporation merely by selling goods or services, any more than you can be married merely by cohabiting with someone – in both cases you need to obtain legal status - Michael Jensen: o The public corporation is the nexus for a complex set of voluntary contracts among customers, workers, managers, and the suppliers of materials, capital, and risk bearing. This means the parties contract, not between themselves bilaterally, but unilaterally with the legal fiction called the “corporation”, thus greatly simplifying the contracting process. The rights of the interacting parties are determined by law, the corporation’s charter, and the implicit and explicit contracts with each individual. - The theory of the firm is concerned empirically with the implications of various actual or possible laws and contracts, and normatively with the interpretation or reform of law, on the one hand, and with the justification of the rights and duties assigned to different agents or grouped involved with the firm, on the other. Coming to Terms with the Public Corporation - Berle and Means drew attention to what they saw as dramatic recent changes in American Capitalism o By emphasizing the separation of ownership (widely dispersed among uniformed, and largely indifferent, shareholders) and control (in the hands of a professional management clique able to amass corporate power to consolidate its own interests), they helped to transform our concepts of ownership and property in a corporate setting, and they focused attention on what would come to be seen as the agency problem at the heart of corporate governance - Firms can avoid some of the transaction costs of purely contractual relations in the market - The governance structures in question may be dictated in part by the corporate law in a firm’s jurisdiction; in part by other regulatory law, such as federal SEC rules or legislation; in part by nongovernmental regulators, such as stock exchanges; in part by the firm’s charger; in part by board or management initiatives - Since the public corporation is the type of firm that has in fact come to dominate most sectors in developed market economies, most debates over the theory of the firm concentrate on explaining, justifying, or reforming the special features of the corporate form - Five essential features of the modern corporation in all major market economies: o 1) Legal personality: the single contracting party that coordinates the activities of suppliers of inputs and consumers of products and services. Overlooked core element is the ability of the firm to own assets that are distinct from the property of other persons, such as the firm’s investors. The corporation owns itself – creditors of its shareholders and managers have no right to any of its assets o 2) Limited Liability: creditors of the firm have no right to those of the shareholders or managers. Since an individual’s creditors and a corporation’s creditors both have comparative advantage at monitoring their respective debts, limited liability should lower cost of capital for both the firm and its investors. Shifting downside business risk from shareholders to creditors, limited liability enlists creditors as monitors of the firm’s managers, a task which they may be in a better position to perform o 3) Delegated Management with a Board of Directors: Corporate law in US and elsewhere treats the board as formally distinct from both management and shareholders. Invests the board with authority and control. The board of directors is not a mere agent of the shareholders, but rather a body whose powers are original and undelegated. While directors may have formal power, in practice their ability to monitor or control managers can be very limited o 4) Transferable Shares: owners of corporate shares can freely transfer their shares. Having shares with this amount of liquidity also enables investors to diversify their holdings and minimize their risk, and in so doing it, too, reduces the cost of capital for the firm o 5) Investor Ownership: The nature of corporate ownership, and the de facto ownership rights of shareholders evolve over time. The two rights that typically define corporate ownership are: “the right to control the firm”, and “the right to receive the firm’s net earnings”. - These are simply core elements of the firm in very general terms/ Corporate law, along with all of the other sources of corporate governance noted earlier fills out the meaning and implications of these very general rights with countless specific provisions. - Open question whether management or boards should have special rights to resist hostile or coercive takeovers o The threat of a hostile takeover provides incentive for managers to serve the interests of the corporation by making more productive use of the firm’s assets and resources o Allowing managers to shield themselves may allow lazy, and corrupt managers to maintain their power even if it is not in interest of other stakeholders. - Point of paper: (1) how normatively infused all of the contractual and quasi-contractual relations are between the constituencies interacting with the firm; and (2) how many deeper ethical and political issues seem to arise as we try to describe the rationale or justification for either the handful of core elements that structure the firm or the myriad specific rights and duties that ultimately determine how these rights work in practice Taking Rights and Duties in (and out of) The Nexus of Contracts Seriously - Justice is the first virtue of social institutions, as truth is of systems of thought - Each person possesses an inviolability founded on justice that even the welfare of society as a whole cannot override - For this reason, justice denies that the loss of freedom for some is made right by a greater good shared by others - The principles used to justify governance rights typically consist of a commitment to two interrelated families of values: o Respect for autonomy and freedom of choice  Comes into play when it is what all parties would voluntarily agree too o Promoting human well-being or preference-satisfaction  Comes into play when governance arrangement preferred because it would be more efficient or create more value or wealth - What is the ultimate purpose or objective of the corporation? Whose interest ought it serve? o Answers will depend on answers to: what is the purpose or objective of corporate law? What is the purpose of markets? What is the Purpose or Objective of Corporate Law? - We treat corporate law as a standard-form contract, supplying terms most venturers would have chosen but yielding to explicit terms in all but a few instances - Corporate law is a set
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