Spontaneous Order and the Firm given the following: Discuss how Hayek's 'fatal concept' determines the efficiency of the market system.
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Chapter4SpontaneousOrderandtheFirm.pptPowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University
Spontaneous Order and the Firm
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CHAPTER 4
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Hayek and Spontaneous Order
- F. A. Hayek
Failure of a socialist or totalitarian system is inevitable
Could not organize and allocate resources like the free market does
Cannot determine prices, quantities, resource allocations, and the like, exactly like a free market would
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Hayek and Spontaneous Order
- Firm - organization
Leader (chief executive officer, president)
Telling people what to do and when to do it
Allocating resources
Even setting prices
Resources are allocated within a firm
People trade their labor services to a firm in return for compensation
Owners of land and capital trade the services of their resources for compensation
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The Existence of the Firm
- Self-sufficient individuals
Produce what they need to sustain themselves
- Specialization
Gains from trade
Could be risky
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The Existence of the Firm
- System of cooperation
Based on contracts
Reduce the risk involved in being a sole proprietor
Gain from specialization and trade
Revenues created by the team
Pay the agreed upon salaries
What is left goes to the owners
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The Existence of the Firm
- Risk - shifted to the owners
Compensated with residual income
- The firm allows
Risk-averse people to shift some of their risk to the owners
Those who are not as risk-averse to gain from taking on some risk
- Contracts
Laid out exchanges that were to occur
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The Existence of the Firm
- Complete contract
Accounts for every contingency
No need for firms
Individuals - independent contractor
Huge transaction costs
- Incomplete contracts
There is no way that every possible event can be contracted for
We need firms
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The Monitor or Boss
- Firms
Enable people to specialize and gain from trade
Allows people to reduce their risk
More efficient than attempting to write a set of complete contracts
A “team”
Incentives to “free ride”
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The Monitor or Boss
- The monitor
To reduce the incentive for free riding
The manager – comparative advantage
Measure the contributions of each member of the team
Ensure that each contributes appropriately
Fire or discipline members when necessary
- A firm replaces a market
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Figure 4.1
The team is created to reduce risk and enable specialization according to comparative advantage. But in the team there is an incentive for members to free ride. A monitor is appointed to minimize free riding.
A Firm: Team Members’ Relationship to Manager/Monitor
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The Monitor or Boss
- Firms exist because of:
Incomplete contracts
Asymmetric information
Not all contingencies can be contracted for
Prohibitive transactions costs
Team product
Reduce risk and enable gains from specialization and trade leads to free riding
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The Monitor or Boss
- Firms exist because of:
Incentives
Hierarchical form minimizes free riding
Compensation based on residual income - managers appropriately monitor employees
- Democracy versus Dictator
Democracy - not necessarily the most efficient form of governance
Firms - select a “benevolent” dictator
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The Monitor or Boss
- Firm’s dictator
Subject to a market test
Monitored by the Board of Directors
Can be driven out of office
Most run the firm efficiently
- The firm
Provide incentives and induce people to voluntarily behave as desired
Run efficiently or it will disappear
Efficient size
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Figure 4.2
In a simple view, the beginning and structure of a country and a firm are similar. In a state, citizens voluntarily agree to contract with a state, that is, a government. The form of government may be some type of democracy or some version of a totalitarian system. In a firm, individual sole proprietors voluntary agree to specialize and share output. They contract with a monitor, someone who is chosen to minimize free riding. The monitor or CEO is subject to a market test.
Analogy between a Country and a Firm
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Boundaries of the Firm
- Boundaries of a firm (size)
Deep - vertical structure
How much of the supply chain a firm includes in-house
Wide - horizontal structure
Firm’s scope
How many different activities the firm includes in-house
Organizational platform, architecture
Internal organization
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Boundaries of the Firm
- Supply chain
Process
Begins with the acquisition of raw material
Ends with the distribution and sale of finished goods
- Vertical boundaries
Supply chain activities that the firm performs itself
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Boundaries of the Firm
- Vertically integrated firm
Firm carries out more than one step in the vertical chain itself
- One firm’s relationship to another
Upstream in the supply chain
Downstream in the supply chain
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Boundaries of the Firm
- Make-or-buy decision
Perform an upstream or downstream activity itself [make]
Special competence itself
Avoid hold-up problems
Monopoly inefficiency
To keep information private
Purchase it from an independent firm [buy]
Others are more proficient
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Boundaries of the Firm
- Horizontal boundaries
The scope of the firm
Varieties of products and services that the firm produces
Activities carried out by the firm at one specific level on the value chain
Defined by efficiency
- Rationales for horizontal expansion
Economies of scope
Transactions costs
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Boundaries of the Firm
- Economies of scope
Per-unit cost declines as a firm increases the variety of activities it performs
“Leveraging core competencies,” “synergies,” “competing on capabilities,” “mobilizing invisible assets”
In advertising
Firms that sell a variety of products or that sell in many markets
From R&D spillovers
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Boundaries of the Firm
- Boundaries of the firm
Limits to the size of a firm
Occur in both vertical and horizontal directions
Vertical boundary - bringing upstream and downstream transactions under the umbrella of the firm
Horizontal boundary – market share and scope
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Figure 4.3
This is an illustration of how a pharmaceutical makes its way from raw materials to your medicine cabinet.
Supply Chain
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Boundaries of the Firm
- Boundaries of the firm
If bringing one more activity in-house costs more than the benefits it creates
Marginal cost equals marginal benefit
- Marginal benefits of bringing transactions in-house
Benefits from specialization and reductions in transactions costs
Decline as more transactions are made rather than bought
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Boundaries of the Firm
- Marginal cost of bringing transactions in-house
Rises as additional transactions are made rather than bought
Managers lose control over the transactions
Additional managers are brought on board
Larger and larger bureaucracy
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Figure 4.4
Make or Buy
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The marginal cost of bringing a transaction in-house rises as more and more transactions take place inside the firm—the make decision. The marginal benefit of bringing transactions in-house declines as more and more decisions occur in-house. The intersection of the lines indicates the boundaries of the firm.
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Governance
- Governance
Ways in which rights and responsibilities are distributed
Define the decision-making systems and structure that enforce private property rights
Good: enforce private property rights efficiently
Bad: interfere with private property rights; enforcing them inefficiently
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Governance
- Governance system for a firm
Defining, protecting, and enforcing property rights
Board of Directors and CEO
Good: preferences of shareholders, owners
Bad: CEO’s preferences; personal gain; corruption
- Corruption
Governance is not transparent
Information is asymmetrically distributed
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Principal-Agent Issues and Revolution
- Principal-agent problem
A principal and his agent have differing objectives
The monitor – has different objectives
Hired to ensure that the team maximizes performance
If paid a fixed salary - little incentive to act in the owner’s best interests
If receives residual income - more likely to ensure the team is productive
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Principal-Agent Issues and Revolution
- Industrial revolution
Owner - hire a professional manager to run the company
Separation of ownership and control
Hired managers controlled the company
Owners, shareholders, paid little attention to the company
Conflict of interest - a principal-agent problem
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Principal-Agent Issues and Revolution
- Complete contracts
Contract - specify how the manager should perform in every state of the world
Perfectly tie management and ownership interests together
Not feasible
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Principal-Agent Issues and Revolution
- Incomplete contracts
Make the manager an owner
Reduced incentive to act in ways that harm owners
Create a monitor for the monitor
The Board of Directors
May have different objectives than owners – principal-agent problem
Need a good governance system
Ensures transparency
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Principal-Agent Issues and Revolution
- Bad government – revolution
External revolution - one country takes over another and imposes a government
Internal revolution - citizens rise up and institute a new government
- Faulty governance in firms
Firms may be taken over
Leaders may be changed
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Principal-Agent Issues and Revolution
- Bad government – revolution
External revolution - one country takes over another and imposes a government
Internal revolution - citizens rise up and institute a new government
- Faulty governance in firms
Firms may be taken over
Leaders may be changed
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Principal-Agent Issues and Revolution
- 1976 to 1994: 45,000 control transactions
Mergers, tender offers, divestitures, LBOs
Over $3 billion
- Examples of faulty governance
General Motors - losses of $6.5 billion in 1990 and 1991
Remove the CEO
Taken over by the government in 2008
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Principal-Agent Issues and Revolution
- Examples of faulty governance
IBM - losses of $3 billion in 1991 and a loss of about 65% of its value
Change the CEO
Eastman Kodak - failed to adjust to competition
BP - oil well blowout in the Gulf of Mexico in 2010
Heavy cash outlays; struggle for BP to survive
Replace the CEO
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Principal-Agent Issues and Revolution
- Private equity firms
Groups of private investors
Objective: purchase companies and make them more efficient
Fix them, grow them, sell them in 3-5 years following acquisition
Own: Hertz, Neiman Marcus, and Toys “R” Us
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Principal-Agent Issues and Revolution
- Revolutions
Can reduce the confiscation of private property by the governing group
Costly
Better: high quality governance and revolution was not necessary
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Principal-Agent Issues and Revolution
- Enron
Highly successful for a few years
As it moved from a pipeline company to an energy trading company
Slowdown in profit growth
Illegal and unethical behaviors
Bankruptcy in 2001
Officials were thrown into jail
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Principal-Agent Issues and Revolution
- 2008 housing bubble collapse
Major Wall Street firms collapsed
Actions of some divisions were not transparent
Too leveraged, overloaded with “toxic” assets
Goldman Sachs, Lehman, J.P. Morgan, Merrill Lynch
Bank of America, Wachovia, HBS
Forced to merge with others
Acquire huge government bailouts
Or go bankrupt in 2008
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Analogy between Markets and Firms
- Markets
Private property rights must exist and be secure
- Firms
Private property rights of decision makers must exist and be secure
Who owns what
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Property Rights in the Firm
- Property rights in a firm
Rights to the services of the resources
Rights to make decisions regarding the use of those resources
Each employee needs to know exactly what he “owns”
What he is responsible for
What decisions he has the right to make without checking with a boss
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