Theory of the Firm

Pamela Marzon
Transaction Cost Theory

Transaction 01 04
03
01 02
A transaction refers
to an exchange of Internalizin
goods or services. Trading Long- g the
Transactions can be in spot term transaction
performed in the markets contracts within the
following three ways: firm
 Transaction Cost Theory

04
This term is believed to have been coined
by Ronald Coase, a British economists.
This refers to costs that will occur
whichever method of transaction is used
and it varies according to the method.
Transaction Cost Theory

A. Coordination Cost 01 04
03
01 02
Search Cost Bargaining Cost Contracting Cost

These are the costs

These are the The costs required to
associated with
costs related to make sure that the
looking for relevant
coming to an other party does not
information and
agreement that is veer from the terms
meeting with agents
agreeable to the of the contract, and
with whom the
parties involved in taking the necessary
transaction will take
drawing up a or appropriate action
place.
contract. if the other party
violates those terms.
Transaction Cost Theory

01
02 04
B. Motivation Cost
01
Hidden Hidden
Information
These costs Action
Actions taken by
are often Where one party in a
transaction has more
one side of an
economic
referred to as information than the
other
relationship that
the other side of
agency costs. the relationship
cannot observe
Transactions have a number of attributes which affect the
above costs and therefore affect the way in which they are
conducted.
ASSET SPECIFICITY

FREQUENCY

COMPLEXITY
RELATIONSHIP WITH
OTHER TRANSACTIONS
 Motivation Theory

04
This theory examines the underlying
factors that cause people to behave in
certain ways.
 Motivation Theory

01 04
01 Altruistic Behavior 02 Spiteful Behavior
Any behavior which confers a A behavior which imposes a
benefit to others, while cost on others, while also
involving a cost to the involving a cost to the
originator of the behavior, with originator of the behavior, with
no corresponding material no corresponding material
benefit benefit.
 Property rights theory

The focus is on the issue of ownership;

the nature of ownership and its
relationship with incentives to invest and
bargaining power are the key features of
this model. This is based on Sanford
Grossman and Oliver Hart’s seminal
paper in1986.
Property Rights Theory

01 04
01 Residual Control 02 Residual Claims
This refers to the owner’s It is a fundamental feature of
decisions regarding the asset’s ownership of an asset that the
use are circumscribed by law owner is entitled to receive
and by any other contract income from it.
involving the rights of other
parties to use of the asset.
 Transactions have a number of attributes which affect the costs and
therefore affect the way in which they are conducted

01 02 03 04

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THE BASIC PROFIT-
MAXIMIZING MODEL
 Property rights theory

The focus is on the issue of ownership;

the nature of ownership and its
relationship with incentives to invest and
bargaining power are the key features of
this model. This is based on Sanford
Grossman and Oliver Hart’s seminal
paper in1986.
Basic Profit-Maximizing Model (BPM)

This theory prescribes that a firm will

produce the output where marginal cost
equals marginal revenue.
Basic Profit-Maximizing Model (BPM)

Figure 2.1 illustrates a rising marginal cost

(MC) curve, where each additional unit costs
more than the previous one to produce, and a
falling marginal revenue (MR) curve,
assuming that the firm has to reduce its price
to sell more units. The output Q* is the profit-
maximizing output. If the firm produces less
than this it will add more to revenue than to
cost by producing more and this will increase
profit; if it produces more than Q* it will add
more to cost than to revenue and this will
decrease profit
 Basic Profit-Maximizing Model (BPM)

The basic profit-maximizing model incorporates the following assumptions:

1. The firm has a single decision-maker.
2. The firm produces a single product.
3. The firm produces for a single market.
4. The firm produces and sells in a single location.
5. All current and future costs and revenues are known with certainty.
6. Price is the most important variable in the marketing mix.
7. Short-run and long-run strategy implications are the same.
 Limitation of BPM

01 02 03 04
The measurement of profit. Risk and uncertainty. Multiproduct firms.
1 The agency problem.
It is important to realize The problem of
We have now seen As soon as we start to
that the concept of profit analyzing the behavior
that whenever there consider longer time
is an ambiguous one, of firms producing
is more than a single horizons the existence of
since it can be defined multiple products can
decision-maker there risk and uncertainty
and measured in different only be partly solved by
are inevitably going becomes important. As
ways. Furthermore, it is modelling the situation
to be agency costs, mentioned in the previous
unrealistic to assume that in terms of drawing
even if we regard chapter, this relates not
decision-makers should multiple graphs (or
managers and other only to the measurement
only consider a short-term specifying multiple
agents as being of profit but also to the
horizon like a year as far equations). Problems of
honest and co- agency problem, since
as measuring profit flows interactions on both the
operative, rather than principals and agents
are concerned. demand and cost sides
self-seeking frequently have different
still remain.
opportunists. attitudes to risk..
 USEFULNESS OF BPM

1. Welfare and efficiency implications 04

- The first function concerns the provision of relevant information to
buyers and sellers, while the second is concerned with motivating
buyers and sellers to act according to the prices charged.

2. Ability to explain and predict

- Regardless of how nice and neat a set of conclusions is, such
conclusions are useless in practice if the model underlying them is
unable to produce accurate explanations and predictions.
THE AGENCY PROBLEM
 Agency Theory

-This examines situations where agents are charged

with carrying out the desires of principals. Since we
have now seen that different individuals are
generally attempting to maximize their own
individual utilities, there is often a conflict of interest
between principal and agent.
- This is concerned with designing incentives so as
to correct for this situation in the most efficient
manner.
1. CONTRACTS AND BOUNDED RATIONALITY

CONTRACT
A contract would require the following conditions:
1 All possible eventualities must be foreseen.
2 These eventualities must be accurately and unambiguously specified.
3 In the future it must be possible to determine which eventuality actually occurred.
4 Courses of action for each eventuality must be determined.
5 The parties must be willing to abide by the terms of the contract, with no desire to
renegotiate.
6 The parties must be able to observe freely the behavior of the other parties to
ensure that the terms of the contract are being met.
7 The parties must be willing and able to enforce the contract if the terms are not
met.
 Contracts and bounded rationality

BOUNDED RATIONALITY
This means that people cannot solve problems
perfectly, costlessly and instantaneously. Incomplete
contracts are sometimes called relational, in that
they frame the relationship between the parties but
do not lay down detailed contingencies or plans.
Incomplete contracts lead to the problems of hidden information and hidden action

2. HIDDEN INFORMATION

- Sometimes this is referred to as asymmetric information or

hidden information, meaning that one party to a transaction
has more information regarding the past that is relevant to
the transaction than the other party or parties.
- This situation provides an incentive for pre-contract
opportunism; this means that one party can try to take
advantage of the other by obtaining better contractual terms
than they would obtain under conditions of perfect
information.
Incomplete contracts lead to the problems of hidden information and hidden action

3. HIDDEN ACTION

- Sometimes referred to as the problem of moral

hazard, in that the behavior of a party cannot be
reliably or costlessly observed after entering a
contract.
- This provides an incentive for post-contract
opportunism.
 4. CONTROL MEASURES

The functions of these measures are:

(1) to enable the organization to operate more efficiently,
both in terms of its external transactions in the relevant
markets and in terms of transactions internal to the
organization
(2) to align the interests of the various constituent parties in
the firm, managers and other employees, with those of the
shareholders.
4. CONTROL MEASURES

1. Increased monitoring
2. Screening
3. Signalling
4. Risk-pooling
5. Internalization
6. Structure of pay incentives.
 Limitations of Agency Model
01 02 03
It focuses on the conflicts
of interest between The model ignores reputa
It ignores co-operative, or
principal and agent and tional effects, meaning th
altruistic, behavior. It is th
assumes that agents will at firms can benefit from
us claimed to misunderst
indulge in self-seeking establishing a good reput
and and
opportunistic behavior. In ation by showing themsel
mispredict many relations
other words the standard ves repeatedly to be relia
hips within firms involving
model is based on the ble and honest; this obvio
managers as either princi
neoclassical narrow self- usly discourages opportu
pals or agents
interest model of nism.
motivation.
MEASUREMENT OF PROFIT
 Nature of measurement problems
Ambiguity in measurement
Ambiguities in the measurement of profit can lead to
serious problems in terms of efficiency and the
allocation of resources. These are measurement
that involves estimates rather than precise
measures such as:

Depreciation, Bad debts, Stock option offerings,

‘One-off ’ losses, Off-balance-sheet finance,
Human and other intangible assets
 Nature of measurement problems
Restriction to a single time period
The concept of profit that is relevant in the current
context is that it is normally related to a single
time period, such as a year. Any owner of an
asset is going to be interested in the stream of
earnings or benefits from that asset, not just
the benefits in a single time period.
 Nature of measurement problems
Restriction to a single time period
The value of a firm can be measured in the same
way as the value of any asset.
 SHAREHOLDER-WEALTH
MAXIMIZATION MODEL (SWMM)

This is a superior model because it takes into

account profits in all future time periods, not just
those in the present. As such it represents a long-
run profit maximization model.

The SWMM has certain limitations because it

ignores the fact that managers tend to have
better information than shareholders and
investors.
 MARKET PENETRATION STRATEGY
This generally involves entering a market with a
low price in order to achieve a substantial market
share, and then later raising the price, relying on
brand loyalty to maintain market share.
EFFICIENT MARKETS HYPOTHESIS

A theory that states that the share price and value

of the firm incorporate all the information that is
publicly available regarding the firm’s prospects.
MULTIPRODUCT
STRATEGIES
 PRODUCT LINE PROFIT MAXIMIZATION

It uses bait-and-switch tactic. The goal was

simply to get potential customers to visit the
showrooms, attracted by the low price. In such a
situation it is common practice for the salesforce
to try to persuade the customer to buy a more
expensive model or model version. It maximizes
profit on the product line taken as a whole, by
persuading people to buy more expensive cars
with a much higher profit margin.
 PRODUCT MIX PROFIT MAXIMIZATION

It uses bait-and-add tactic. When a consumer sees a special

offer of an item, they may decide to shop at that store rather
than a different one; but while they are there they will usually
pick up a number of other items, at the normal price, that
they might have bought anyway, but not necessarily at that
store. Thus the firm will not be maximizing its profit on each
and every item, since some items may be sold at below cost,
but it may be maximizing profit on the whole product mix by
attracting customers into the store who would not ordinarily
shop there.
 CASE STUDY

How Technology Is Changing Health Care in India

https://knowledge.wharton.upenn.edu/article/techn
ology-changing-health-care-india/
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