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Firms are major actors in the economy and we will use this and the next unit to explain how they work. But while firms are actors—and in some legal systems are treated as if they were individuals—firms are also the stage on which the people who make up the firm employees, managers, and owners act out their sometimes common but sometimes competing interests.
To understand the firm, we will model how employers set wages and employees respond.
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We have already seen, in earlier units, the importance of work, and firms, in the economy:. We illustrated each of these conclusions using models that illuminate some aspects of the economy, while setting aside others. In Unit 2, we did not consider how the length of the working day was determined while the economy was growing. In Unit 3, we did not model how the wage or the marginal rate of transformation of free time into goods was determined when we analysed a decision on working hours. In Unit 2 we told a story of conflicting interests over wages, but we did not model strategic interaction and bargaining until Units 4 and 5.
And in Unit 5 we used the story of just two imaginary people called Bruno and Angela to model how bargaining may affect the Pareto efficiency and fairness of allocations. In this unit, we study how, in the modern capitalist economy, the coordination of labour takes place within firms. We model how wages are determined when there are conflicts of interest between employers and employees, and look at what this means for the sharing of the mutual gains that arise from cooperation in a firm.
In Unit 7, we look at the firm as an actor in its relationship with other firms and with its customers. The economy is made up of people doing different things, for example producing Apple display modules or making clothing for export. Producing display modules also involves many distinct tasks, done by different employees within Toshiba or Sharp, the companies that make them for Apple. Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways: firms and markets. Among the institutions of modern capitalist economies, the firm rivals the government in importance.
John Micklethwait and Adrian Wooldridge explain how this happened. John Micklethwait and Adrian Wooldridge. Why do firms work the way they do? For example, why do the owners of the firm hire the workers, rather than the other way around? Randall Kroszner and Louis Putterman summarize this field of economics. Randall S. Kroszner and Louis Putterman editors. Cambridge: Cambridge University Press. So in this unit we study firms. In the units to follow, we study markets.
Herbert Simon, an economist, used the view from Mars to explain why it is important to study both. Looking at Earth through a telescope that revealed social structure, what would our visitor see? Companies might appear as green fields, he suggested, divisions and departments as faint contours within. Connecting these fields, red lines of buying and selling. Within these fields, blue lines of authority, connecting boss and employee, foreman and assembly-worker, mentor and mentee. Traditionally, economists had focused on the market and the competitive setting of prices.
But to a visitor from Mars, Simon suggested:. Organizations would be the dominant feature of the landscape. He was celebrated in departments of computer science, psychology, and, of course, economics, for which he won the Nobel Prize in A firm, he pointed out, is not simply an agent, shifting to match supply and demand. It is composed of individuals, whose needs and desires might conflict. In what ways could these differences be resolved? When the desired task is easy to specify in a contract, Simon explained that we could view this as simply work-for-hire.
But high uncertainty the employer not knowing in advance what needs to be done would make it impossible to specify in a contract what the worker was to do and, in this case, the result would be an employer-employee relation that is characteristic of the firm.
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Understanding how contract work turns into employment only implies that we understand a particular relationship between two members of an organization. What makes a good organization? This is a question for psychologists as much as economists, because we know that incentives that tie individual rewards to the success of the organization appear to have little effect. Both were interested in how societies could thrive in the face of uncertainty and imperfect agents. For Hayek, the price mechanism was all: a device to collect and process vast quantities of information, and so synchronize systems of arbitrary size.
But for Simon, the price mechanism needed to be supplemented—even supplanted—by institutions and governments better equipped to handle uncertainty and rapid change. By the time of his death in , Simon had seen many of his ideas reach the mainstream. Behavioural economics has roots in his attempts to build economic theories that reflect empirical data.
The way that labour is coordinated within firms is different to coordination through markets:. The idea of private property specifically limits the things a government or anyone else can do with your possessions.
In a firm, by contrast, owners or their managers direct the activities of their employees, who may number in the thousands or even millions. Walmart is an exceptionally large firm, but it is not exceptional in that it brings together a large number of people who work together in a way coordinated by the management to make profits. Unlike flash mobs, firms do not form spontaneously and then disappear. Like any organization, firms have a decision-making process and ways of imposing their decisions on the people in it. Figure 6. The owners, through their board of directors, decide the long-term strategies of the firm concerning how, what, and where to produce.
They then direct the manager s to implement these decisions. Each manager assigns workers to the tasks required for these decisions to be implemented, and attempts to ensure that the assignments are carried out. The green arrows represent flows of information. The upward green arrows are dashed lines because workers often know things that managers do not, and managers know things that owners do not.
Since owners or managers do not always know what their subordinates know or do, not all of their directions or commands grey downward arrows are necessarily carried out. It could tempt its customers with a special offer, but unlike the employer with its employees, it cannot require them to show up. When you buy or sell something, it is generally voluntary. In buying or selling you respond to prices, not orders. The firm is different: it is defined by having a decision-making structure in which some people have power over others. Ronald Coase, the economist who founded the study of the firm as both a stage and an actor, wrote:.
Coase pointed out that the firm in a capitalist economy is a miniature, privately owned, centrally planned economy. Its top—down decision-making structure resembles the centralized direction of production in entire economies that took place in many Communist countries and in the US and the UK during the Second World War. The difference between market interactions and relationships within firms is clear when we consider the differing kinds of contracts that form the basis of exchange. A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use.
A rental contract on an apartment does not transfer ownership of the apartment which would include the right to sell it ; instead it gives the tenant a limited set of rights over the apartment, including the right to exclude others including the landlord from its use. Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and to accept the authority of the employer over the use of his or her time while at work. The employer does not own the employee as a result of this contract.
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If the employer did, the employee would be called a slave. To summarize:. Firms differ from markets in another way: social interactions within firms sometimes extend over decades, or even a lifetime. In markets, we shop around, so our interactions are typically short-lived and not repeated. One of the reasons for this difference is that working in a firm—as either a manager or an employee—means acquiring a network of associates who are essential for the job to be done well.
Some of our workmates will become our friends. Managers and employees also acquire both technical and social skills that are specific to the firm they work for. Oliver Williamson, an economist, termed these skills, networks, and friendships relationship-specific or firm-specific assets because they are valuable only while the worker remains employed in a particular firm.
When the relationship ends, their value is lost to both sides.