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2.Thoeryoffirms.pptx2. Theory of the firm
Chap 1
Outline
Where firms come from
Forms of firms
Firm structure
Conflicts within a firm
Start from a simple example
Tom and Jerry, two lemonade stand owners on both sides of a street
They both encounter
Similar costs & expenses: inventory, marketing,
Risk of losing customers on the other side of the street
Competition from each other
Consequence: low profitability
#1 Theory of the firm: profit maximization
One day they suddenly realize this issue and decide to work together (i.e., partnership)
Profit maximization
Bigger scale
Less risk
Higher productivity
Less competition
Can a firm control the entire market? Not completely by 1) the “invisible hand”, 2) antitrust laws
When a firm involves multiple agents
Consider the following scenarios:
Tom is elder and wants Jerry to work longer hours
Tom wants to hire his lazy friend Butch as an assistant
Tom wants to use the partnership’s money to buy a truck he claims to use for shipping lemons but very likely for his own convenience
…
What would Jerry think?
#2 Theory of the firm: contract theory
Contract theory: a firm is a combination of contracts between the firm and employees
A contract defines:
Duty: shoulds + should-nots
Compensation: money + privileges
A contract should
Discourage agency issues
Free-riding: benefiting without making own efforts
Moral hazards: self-benefiting while hurting the company
Align the incentive of all agents to work for the best of the company
Firm structure
Tom and Jerry are experts in making lemonade but not in other areas
To grow their business, they recruit talents on different jobs
Firm hierarchy
Owners
Managers
Employees
#3 theory of the firm: transaction costs
Coase (1937): costly to make “transactions” with the market
Say Tom and Jerry need bookkeeping
A transaction with the labor market for accounting services
Choice #1: find one, pays for a job, and let go; repeat whenever needed
Choice #2: find one, let stay as an employee; no need to repeat
In many cases, #2 is better, hence firm emerges
Managers, sales, marketing, logistics, legal, etc.
When long-term employment makes more sense, firm arises
Firm types
Main difference in
Liabilities
Ownership
Tax
Quick summary
Understanding origin of firms
Profit maximization
Contract theory
Transaction costs
Firm structure
Types of firms
C corporation
Separation of ownership and control
Agency conflicts within a firm
Role of board of directors and CEO
Next…
Capital budgeting: how firms make investment decisions
