EC132 Notes
L2: Firms: What are firms? (3 economic definitions):
A supplier of goods to a market, characterized by a ‘production function’ and a
‘profit function’ according to Cournot and others. Classical.
A decision making process including the pattern of communication and relations
between human beings. A network – a way of linking individuals together. Simon.
Behaviouralist
A legal entity able to enter into binding agreements with external parties and a
governance structure for regulating internal activity. Coase and others. Separate to
contracts between individuals. Transaction cost
Traditional view is that a firm converts inputs to outputs and sells that to consumers.
However, this misses the important internal governance structure e.g. a manager is not
making the product that is sold, a manager plays an important monitoring role – planning
for the future
Each different way of viewing a firm allows us to explore a different phenomenon:
Classical – competitive behaviour – what prices are set, quantity produced
Behaviouralist: Adaptations vs coordination – coordination problems within networks
Transaction cost: make vs buy – when a firm would be an efficient form of production.
Allows for specialisation.
Note: In EC132, a firm, company and organisation are all interchangeable words, but in
microeconomics only use the word firm
Why do they exist? Firms vs Markets: Firms: Centralised decision making; coordination via
communication; personal interaction
Markets: Decentralised decision making; coordination via prices; anonymous interaction
Within a capitalist economy, markets and firms both exist. Phenomena which are both
persistent and pervasive must exist for a reason.
Firms exist even though the same activity could be performed by the market… so there must
be a ‘cost’ to using the market. This cost is a transaction cost. This idea led to many great
and non-obvious insights: which activities are done internally vs contracted out and how
governments should regulate private industries.
Transaction costs can be real costs or ‘cost’ of time wasted: e.g. third party brokerage costs
(costs of setting up a contract), negotiating/bargaining costs, search costs. But also,
coordination costs, incentive costs. For example, within a firm easy to incentivise e.g.
promotions but in the marketplace there may be many different incentives e.g. they will
work for other customers so how much effort they put into your work depends on their
relationships with other customers.
Transaction cost is the cost of doing something while the opportunity cost is the cost of the
next best alternative foregone.
,L3: Cooperation problems: Conflict between best individual outcome and mutual benefit.
Cheating is the major concern
Prisoner’s Dilemma: Two men, charged with a joint violation of law, are held separately by
the police. Motivation to cheat, better for all scenarios.
For market economies to develop, the prisoner’s dilemma had to be solved. The economic
historian Avner Grief called this ‘the fundamental problem of exchange’. Example of agent
selling your goods and higher incentive to steal than be paid the wage. This temptation to
cheat, if unchecked, is fatal to market enterprise and is known as Cooperation problems.
This is where the individual’s incentives does not align with the group
To solve the problem you can hire them – provide an incentive not to cheat this one time as
in the long term you can have a job forever, it keeps people honest.
Coordination problems: Many feasible mutually beneficial outcomes.
restaurant example: Chefs are Italian and experts in Italian food. Some diners like only
Italian food, others only French food.
The chefs would want to coordinate their decision.
Bad outcome: both open Italian restaurants
Worst outcome: Both open French restaurants
These bad outcomes are called coordination failures
Coordination with external environment (i.e.
competitors) is important (but difficult as that may be collusion) as well as internal
coordination. This includes coordination with suppliers and contractors
The Mars Climate Orbiter: a real world example of coordination failure. Wrong metric units
so it did not have the right trajectory to Mars. Ground based software provided by a
contractor used imperial units. Inter organisational coordination failure
Summary: Cooperation Problems: Conflict between best individual outcome and mutual
benefit, cheating is the major concern, not always strategic
Coordination Problems: Many feasible mutually beneficial outcomes, Coordination is the
major concern, Heavily strategic.
Pure coordination problems only require agreement. Others may require a way to divide the
surplus.
How can we solve these problems? For cooperation problems we need: a way to align
incentives or a way to forge an agreement and prevent cheating (contracts).
For coordination problems we need: a way to align our expectations about what the other
will do or a way to control the actions of one or both parties (contracts).
, L4: Contracts: Spot contracts: Immediate and one off transaction using established market
prices and terms of trade. e.g. Using a taxi – no need to sign an official contract
Best for simple transactions where both parties know what they are getting.
No further commitment on both sides.
Pros: low transaction cost, easily and widely implementable
Cons: can lead to short term opportunism e.g. selling dodgy goods, difficult to encourage
long term investment, exposed to price volatility
Classical contracts: Legally enforceable contract detailing specific terms of exchange. Long-
term and often with finite length. E.g. commercial lease
Desirable for long term transactions
Provides what-if contingencies
Why are classical contracts so important for firms?
Uncertainty is costly to manage e.g. changing input prices
Prevents opportunism (cheating) – e.g. buyers not paying, hold up problem – where
if one party in a contractual relationship does something that is beneficial to both it
is essential that the contract specifies how the benefits will be split between the two
parties. If it does not specify that one party may be able to ‘hold-up’ the other,
extract the full value of that new feature.
Problem with contracts: it is hard to verify the quality of goods. So contracts may guarantee
high quality, but that might be subjective e.g. the taste of a chocolate bar.
Pros: prevent opportunism (legally enforceable so stops cheating), can incentivise mutually
beneficial investments, reduce uncertainty
Cons: High transaction cost (need a lawyer, monitoring breaches in a contract), some things
are non-contractible, require strong legal institutions
Relational contracts: Unwritten codes of conduct sustained by the value of future
relationships. Roles may be informally defined but no explicit ‘terms’. Long-term with no
fixed end point. E.g. boss-employee relationship, bonuses. Also called ‘implicit contracts’
Pros: can incentivise non-contractible outcomes, does not require legal enforcement,
flexible
Cons: Limited applicability (they are open and vague), open to abuse of power, exposed to
cultural misunderstandings (one culture may think a certain behaviour is ok while another
may not).
Note: not all contracts fall in to a single category: e.g. restaurant – spot and relational
Problems with contracts: it is hard to verify the quality of goods. So contracts may
guarantee high quality, but that might be subjective e.g. the taste of a chocolate bar
Pros: prevent opportunism, can incentivise mutually beneficial investments, reduce
uncertainty
Cons: high transaction cost, some things are non-contractible, require strong legal
institutions
Can classical contracts fix cooperation problems?
They lay out what has to be done, and by whom. They are enforceable by legal means.
Contracts could help with incentive problems. E.g. contracted to stay quiet in Prisoner’s D.
L2: Firms: What are firms? (3 economic definitions):
A supplier of goods to a market, characterized by a ‘production function’ and a
‘profit function’ according to Cournot and others. Classical.
A decision making process including the pattern of communication and relations
between human beings. A network – a way of linking individuals together. Simon.
Behaviouralist
A legal entity able to enter into binding agreements with external parties and a
governance structure for regulating internal activity. Coase and others. Separate to
contracts between individuals. Transaction cost
Traditional view is that a firm converts inputs to outputs and sells that to consumers.
However, this misses the important internal governance structure e.g. a manager is not
making the product that is sold, a manager plays an important monitoring role – planning
for the future
Each different way of viewing a firm allows us to explore a different phenomenon:
Classical – competitive behaviour – what prices are set, quantity produced
Behaviouralist: Adaptations vs coordination – coordination problems within networks
Transaction cost: make vs buy – when a firm would be an efficient form of production.
Allows for specialisation.
Note: In EC132, a firm, company and organisation are all interchangeable words, but in
microeconomics only use the word firm
Why do they exist? Firms vs Markets: Firms: Centralised decision making; coordination via
communication; personal interaction
Markets: Decentralised decision making; coordination via prices; anonymous interaction
Within a capitalist economy, markets and firms both exist. Phenomena which are both
persistent and pervasive must exist for a reason.
Firms exist even though the same activity could be performed by the market… so there must
be a ‘cost’ to using the market. This cost is a transaction cost. This idea led to many great
and non-obvious insights: which activities are done internally vs contracted out and how
governments should regulate private industries.
Transaction costs can be real costs or ‘cost’ of time wasted: e.g. third party brokerage costs
(costs of setting up a contract), negotiating/bargaining costs, search costs. But also,
coordination costs, incentive costs. For example, within a firm easy to incentivise e.g.
promotions but in the marketplace there may be many different incentives e.g. they will
work for other customers so how much effort they put into your work depends on their
relationships with other customers.
Transaction cost is the cost of doing something while the opportunity cost is the cost of the
next best alternative foregone.
,L3: Cooperation problems: Conflict between best individual outcome and mutual benefit.
Cheating is the major concern
Prisoner’s Dilemma: Two men, charged with a joint violation of law, are held separately by
the police. Motivation to cheat, better for all scenarios.
For market economies to develop, the prisoner’s dilemma had to be solved. The economic
historian Avner Grief called this ‘the fundamental problem of exchange’. Example of agent
selling your goods and higher incentive to steal than be paid the wage. This temptation to
cheat, if unchecked, is fatal to market enterprise and is known as Cooperation problems.
This is where the individual’s incentives does not align with the group
To solve the problem you can hire them – provide an incentive not to cheat this one time as
in the long term you can have a job forever, it keeps people honest.
Coordination problems: Many feasible mutually beneficial outcomes.
restaurant example: Chefs are Italian and experts in Italian food. Some diners like only
Italian food, others only French food.
The chefs would want to coordinate their decision.
Bad outcome: both open Italian restaurants
Worst outcome: Both open French restaurants
These bad outcomes are called coordination failures
Coordination with external environment (i.e.
competitors) is important (but difficult as that may be collusion) as well as internal
coordination. This includes coordination with suppliers and contractors
The Mars Climate Orbiter: a real world example of coordination failure. Wrong metric units
so it did not have the right trajectory to Mars. Ground based software provided by a
contractor used imperial units. Inter organisational coordination failure
Summary: Cooperation Problems: Conflict between best individual outcome and mutual
benefit, cheating is the major concern, not always strategic
Coordination Problems: Many feasible mutually beneficial outcomes, Coordination is the
major concern, Heavily strategic.
Pure coordination problems only require agreement. Others may require a way to divide the
surplus.
How can we solve these problems? For cooperation problems we need: a way to align
incentives or a way to forge an agreement and prevent cheating (contracts).
For coordination problems we need: a way to align our expectations about what the other
will do or a way to control the actions of one or both parties (contracts).
, L4: Contracts: Spot contracts: Immediate and one off transaction using established market
prices and terms of trade. e.g. Using a taxi – no need to sign an official contract
Best for simple transactions where both parties know what they are getting.
No further commitment on both sides.
Pros: low transaction cost, easily and widely implementable
Cons: can lead to short term opportunism e.g. selling dodgy goods, difficult to encourage
long term investment, exposed to price volatility
Classical contracts: Legally enforceable contract detailing specific terms of exchange. Long-
term and often with finite length. E.g. commercial lease
Desirable for long term transactions
Provides what-if contingencies
Why are classical contracts so important for firms?
Uncertainty is costly to manage e.g. changing input prices
Prevents opportunism (cheating) – e.g. buyers not paying, hold up problem – where
if one party in a contractual relationship does something that is beneficial to both it
is essential that the contract specifies how the benefits will be split between the two
parties. If it does not specify that one party may be able to ‘hold-up’ the other,
extract the full value of that new feature.
Problem with contracts: it is hard to verify the quality of goods. So contracts may guarantee
high quality, but that might be subjective e.g. the taste of a chocolate bar.
Pros: prevent opportunism (legally enforceable so stops cheating), can incentivise mutually
beneficial investments, reduce uncertainty
Cons: High transaction cost (need a lawyer, monitoring breaches in a contract), some things
are non-contractible, require strong legal institutions
Relational contracts: Unwritten codes of conduct sustained by the value of future
relationships. Roles may be informally defined but no explicit ‘terms’. Long-term with no
fixed end point. E.g. boss-employee relationship, bonuses. Also called ‘implicit contracts’
Pros: can incentivise non-contractible outcomes, does not require legal enforcement,
flexible
Cons: Limited applicability (they are open and vague), open to abuse of power, exposed to
cultural misunderstandings (one culture may think a certain behaviour is ok while another
may not).
Note: not all contracts fall in to a single category: e.g. restaurant – spot and relational
Problems with contracts: it is hard to verify the quality of goods. So contracts may
guarantee high quality, but that might be subjective e.g. the taste of a chocolate bar
Pros: prevent opportunism, can incentivise mutually beneficial investments, reduce
uncertainty
Cons: high transaction cost, some things are non-contractible, require strong legal
institutions
Can classical contracts fix cooperation problems?
They lay out what has to be done, and by whom. They are enforceable by legal means.
Contracts could help with incentive problems. E.g. contracted to stay quiet in Prisoner’s D.
