Organizations versus Markets Notes

Designing
Shifting Nature of Work
o The dynamic between organization and market is shifting: gig economy, AI

E.g. gig economy

Employees Gig workers
Benefits  Various Legal rights  Being able to pick and choose
 Entitled to minimum when they work and for
wage whom
 Work multiple work
Costs  Lack of flexibility for  No minimum wages
work  No legal rights
 Lack bargaining power

The platform needs to solve:

 Search cost problems: deep pools of employers and workers – Network effects
 Quality control problem: standardized tasks, rating mechanisms

E,g, Working from home

The organization should solve:
 When should a worker be able to work from home and when to come in?
 What type of worker needs face to face interaction?
 What is the purpose of bringing people in together?

o Workers are trying to recognize themselves, but unionization rate is decreasing

because of technology change. Social media allows users to
o collect information
o coordinate action
o getting the word out
Corporate Governance

Economic theory of firm

1. Valuation: how should an organization be valued?
2. Financing: distortions associated with different ways of financing (capital structure)
3. Corporate governance*: optimal governance structure for this entity

Corporate governance
o Governance implies the exercise of authority
o Why do we need any form of authority?
o Isn’t the market responsible for allocating all resources efficiently without the
intervention of any authority?
o When do markets work and when do they not?
o Coase (1937) argued that using the market has its costs. Firms alleviate these costs
by substituting the price mechanism with the exercise of authority

When to use firms, when to use markets?

o Goal: cooperate to achieve something together
o 2 methods: market or corporation?

o How do you choose

o Imperfect information: don’t have enough information
o Asymmetric information: have less information than the other side
o Behavioral issues: we don’t know what to do with the information we have
o 5 problems market must solve:
o Coordination and synchronization issues: urgency
 E,g. developing COVID vaccine
o Search costs: how difficult is it to find the worker you are looking for?
 E.g. search costs are high when unstable worker supply and
specialized talent necessary
o Confidentiality: if reveal information, may go to competitors
 E.g. Amazon knows all about your products, and launch competing
products
 Solutions: Patents, contracts, joint investment
o Asset specificity: Exploitation arising from the use of specialized assets
 Why invest in specific assets?
 Economies of repeat dealing in recurring transactions
 Can lead to hold up problems
 o Asymmetric information: Adverse selection and moral hazard problems
 E.g. The lemons problem
o The problems organizations must solve:
o Assignment problem: who gets to decide and when? How should decision
rights be assigned to be best achieve the organization goals?
 Old: CEO in a vertical firm e.g. Ford: all decisions made by him
 New: Decentralized organizations; smart contracts; anonymous
employees
o Incentive Problems: how should individuals be compensated to best achieve
the organization’s goals?
 Old: salary, bonus, options
 New: Multi-dimensional preferences (WFH), gig economies
o Performance Evaluation Problems: How should the performance of the
individuals be evaluated?
 Old: stocks, HR
 New: ratings mechanism, talent marketplace, monitoring technology
o When do markets work as coordinating devices
o Characteristics of a market-based exchange -> exchange of goods is possible
and is voluntary
 Private property rights
 Alienable property rights
o In a competitive, well-functioning market:
 Everyone obtains information by themselves
 No official coordination mechanism
 Scaling up is easy
o When are markets good?
 Market focus on efficiency
 Allocative efficiency: if individuals face the same set of fixed
prices, then a competitive exchange economy results in an
efficient allocation
 Comparative advantage: individuals have different skills; trade
allows specialization according to relative (comparative)
advantage
 Productive efficiency: if firms face same set of fixed costs, a
competitive economy leads to productive efficiency and
allocative efficiency
o Relying on markets is likely to be costly when transactions are characterized
by:
 Urgency
 Confidentiality
 Lots of uncertainty
 High set up costs
o Organisation
o Horizontal boundaries of the firm: diversification benefits
 Scope economies
 Scale economies
 Internal capital markets and external financing costs
  Institutional limits on writing and enforcing contracts
o Vertical boundaries of the firm: 2 tests
 Competitive advantage?
 Does ownership produce greater competitive advantage?
o Case Study: Ford vs Motorcycle in China
o Organization: Ford innovates the first car in 1900s, use in-house assembly
lines to produce. Faces problem of coordination, search costs, confidentiality,
asymmetric information.
o Market: Motorcycle in China. Was expensive because have to get license
from Japan. Break motorcycle parts into 4, and allow everyone in the market
to produce a part of it.
o Case study: Spotify
o Agile management: squadification
 Squad: small team responsible entirely for certain aspects of a
product
 No boss in a squad. only someone called product owner to ensure all
the members of the team have everything they need to do their work
 Have personal responsibility: experiment -> share with teammates ->
get feedback -> fix the problem
o No CEO. Just “system owner” and “chief architect”. Don’t have power to give
orders, and operate like moderators.

o Case study: Lime

 o Problem faced: have to travel distance in order to get one car. It is
everywhere.
o Solve problem: using gig economy to give incentives to people who are
willing to put the bikes back

Market vs Firm
Market Vertical integration
Benefits o Economies of scale o Leakage of private
o Market firms are subject to the information
discipline of markets o Extensive coordination
requirements
o Market power
o Price discrimination
o Double marginalization
Costs o Coordination of production
flow may be compromised
o Private information may be
leaked
o Transaction and contracting
costs may be higher (especially
when significant relationship-
specific assets, investment
efficiency, uncertainty
regarding market conditions,
quality measurement problems,
or externalities)

The Purpose of Firms

Firm is a nexus of explicit and implicit contracts.
Implicit contracts need to establish reputation.
Value of Organizational capital = value of the firm – value of its parts

Corporate governance
to bind yourself not to take advantage of the other parts
 Advantages of constraints
o Agency problem: Other party will not worry that you will rip them off
 o Hold-up problem: Other party will not worry
o Other party will be willing to commit to firm-specific investments
 Types of constraints
o Legal constraints
 Protecting stakeholders
 Employees – explicit contracts
 Creditors – covenants
 Suppliers – Contracts
 Customers – warranties
 Protecting shareholders
 Investors - Control rights (right to vote in corporate matters
and elections of boards of directors)
 External financing – explicit contract
o Structural constraints
 Costly Signaling models: investment in projects
 Project quality can be signaled with the level of ownership
entrepreneur plans to invest in it -> Skin in the game
 Costly Signaling models: Debt policy
 Firm quality can be signaled by the amount of debt the firm
holds
 Costly Signaling models: Dividend policy
 Cash flows can be signaled by amount of dividends the firm
chooses to pay.
 Costless signaling models
 Signal not costly to send e.g. stock splits changes brokerage
incentives
 Signal is not costly to send, however, sending a wrong signal
can affect
 Incentive constraints
 Incentive contracts
o Options
o Share ownership
o Restricted shares
  CEO with higher incentives do not earn higher return (maybe
overconfident)

o Concentration of ownership
 When control rights concentrated in small number of investors with
collectively large cash flow stake, concerted action is much easier.
 Concentration of ownership leverages up legal protection*
 Type of concentration:
 Large shareholders (Private owners, family owners)
 Hostile takeovers (Activist shareholders)
 Large creditors
 World
 US and UK: uncommon
 Israel: breaking up
 Germany: Common
 France: Ccross-ownershp
 Are concentrated owners effective?
 US: large outside shareholders increase the likelihood that a
firm is taken over
 Germany: large shareholders are associated with higher
turnover of directors
 Japan: Firms with large shareholders are more likely to replace
manages in response to poor performance than firms without
them

 Types of family firms

 Type 1 Classical family: exercises both ownership and control
 Type 2 Family ownership but professional managers
 Type 3 Family has little ownership but manages firm (e.g.
Suzuki, Toyota)
 Type 4 Family is a venture capital fund
High Type 2 Type 1
 Ownership Type 3
Low Low  Managerial control  High

 Is family ownership effective?

 PROS - Strong internal culture: stables case of employees,
historical shared background of stories, trust, value-based
leadership, lag on innovation
 CONS – in-fighting (e.g. Porshce and Piech family), too many
family members(different shares, who should decide), too few
family members (e.g. tatas)
 A solution in Japan
o Strategy 1: persuade your daughter to marry a talented
man (can’t choose your son, but can choose sons-in-
law”
o Strategy 2: adopt a star employee as a son
 Preserving control in family firms
o Strategy 1: stick to a tiny global niche
o Strategy 2: Form a close relationship with a local bank
o Strategy 3: Pyramiding

o Strategy 4: Opacity (e.g. Samsung)

o Strategy 5: Multiple classes of shares

o Hostile takeover markets

 Takeovers typically increase the combined value of the target and
acquiring firm
 Takeover targets are often poorly performing firms
 Takeovers are sufficiently expensive
  Activist shareholders

o Credi tor concentration

 Creditors have large investments in the firm
 How effective?
 Japan: reasonably effective
 Germany: also effective
 US: play a role in bankruptcies
 Italy: not that effective

*Concentrated owner Problem:

 In many countries, minority shareholders are not protected.
 Large investors may be too soft.
Will privatization Improve governance?
o Privatization replaces political control with private control by outside
investors.
 Usually creates concentrated private cash flow ownership with
control
 Typically significant improvement in performance of privatized firm
o When does it not work?
 Without the creation of large investors (e.g. water privatization in uk)
 Corporate governance solutions persuade counterparties to enter in a relati0onship
with the firm.
Solutions
(1) Pick the cheapest solution that will engage your counterparty
(2) Make sure the benefits you get from counterparty exceed the cost of the measure