Managerial Theories of Firm
So far, we have analyzed optimal pricing and output decisions of Firms under different markets structures, using the assumption of profit maximization as the objective of a firm. As an alternative to profit maximization, Baumol suggests that Firms maximize sales revenue, subject to the constraint of earning satisfactory level of profits. O. Williamson in his book, Economics of Discretionary Behaviour develops a manager’s discretionary behaviour model. He argues that a manager of a large company, has vast control over the management of the company vis-à-vis the share holders (owners) of the company, who have little control over management of the company. Williamson suggests that managers attempt to maximize managers’ utility. Managerial utility primarily depends on 1) the salaries and other monetary benefits received by the manager, 2) the perquisites enjoyed by the manager, 3) the staff under the control of the manager, and 4) the extent to which the manager can direct the investment of Firm’s resourses.
Herbert Simon
Herbert Simon, who did his Doctorate in Political Science, has won the Nobel Economics Prize for his pioneering research into decision-making process within economic organizations and for his significant contributions to Organizations theory. While analyzing the Firm’s goal, Simon offered an alternative hypothesis to that of the Classical assumption of maximization of profits. Firms, while choosing a particular course of action among several courses available are satisfied with a limited objective of ‘satisfice’ than maximize profits. It is a decision making strategy that aims at adequate rather than an optimal one. The practice of a fixed mark-up over costs in determining market price gives one example of such behaviour. Following the lead of Simon, others like Cyert and March have attempted to develop a Behavioral theory of Firm.
On main contribution of Auman relative to repeated games. Most relationships between decision makers last a long time. In such long term interaction, the different stages are naturally inter-dependant, decision makers react to past experience and take into account the future impact of their choices. Many interesting and important aspects of behavior like rewarding and punishing, cooperation and threats and transmitting information and concealing it, can only be seen in multi-stage situations.
As rightly noted by Avinash Dixit Barry Nalebuff that one of the wonderful aspects by game theory is that it is possible the contributions (most) Nobel economists.
Game theory is useful is understanding price discrimination, it is a stategy where identical products of services are sold at different spices by a monopolist in different markets. One example of price discrimination is students discount in fares offered by Road Transport Corporations. Students are offered by Road Transport Corporation. Students are charged a lower price while other passengers are charged a higher price. The most familiar example of price discrimination is that of an airline pricing . It carries business people and Non-business people (commons). The airline charges first class fares to business people. Who are willing to pay a high price and economy class to common people at a low price. While fixing the First Class and economy class fares, the airline sees that the participant constraint for business people and an incentive compatibility constraint for common people are satisfied. The strategy of separating or screening different buyers with different willingness to pay offering different versions of the product at different prices is called screening by self selection.
The game theory of Entry deterrence is applicable to theory of markets. Entrenched monopolists or oligopolists with to deter new entrants who mould dilute their market power. They can threaten to start a price war that would make entry unprofitable. But mere words may be seen as empty threats; they hard to be made more credible. One device is to set a price lower than the market price would justify, the aim being to convince the new entrant that the incumbent firms’ costs are very low, so the entrant would find the competition is too fierce. The incumbent can also maintain a large capacity, so that they can expand output and start a price war should a new entrant appear. This makes the potential extranet to stay out.
Players use threats promises, commitments and make them credible. A player can enhance the credibility of his unconditional and conditional strategies moves which helps him to practice brinkmanship. Such action by the players are classified into eight categories and illustrated each by dixit and Nalebuff in their book.
Theory of games is applicable to Behavioral economics also which studies deviations from rational behavior. The ultima game is one such example of irrational behaviors . Game theory is extensively used in information economics also. Strategic games players who possess some special information employee strategies like signaling and screening. Game theory is also useful in various types of auctions. It can help the buyers to bid and know when not to bid. But an excellent of game theory applications, in information economics, read the book, the Art of strategy by Avinash Dixit and Barry Nalebuff , Viva Books, New Delhi.
Stackelberg studied first leader-followers interactions, his model is called stackelberg model. It is often used to describe industries in which there is a dominant firm or natural leader and other firms who follow the leader. For example, IBM is often considered as a dominant firm in the computer industry. It may provide a quantity leadership or price leadership.
(Download 5341 stackelberg model of Duopoly 4PDF (SMU)
Sequential game strategies are similar to the strategies followed in stackelberg model. In a sequential game player gets to choose in the first round. Player B gets to observe the first player choice and then he chooses.
Transaction Cost Economics and Transfer Pricing
Though many have contributed to the discussion on transaction cost economics, Williamson’s contributions to the subject have been many and important. His book ‘The Economic Institutions of Capitalism’ (Free press New York) provides a unified treatment of the subject of transaction costs.
Every transaction is placed within the context of a Firm. When undertaking a transaction, parties to the transaction incur several costs like negotiating the contract and drafting the contract before entering into the contract. Ex-post costs are incurred in consummating and safeguarding the deal that was originally struck.
Transaction costs depend on two types of factors: those pertaining to individuals who undertake the transaction and factors specific to the particular transaction. Williamson assumes that human beings are boundedly rational and opportunistic. The level of transaction costs depend on asset specificity, frequency and extent of uncertainty.
Firms in order to minimize transaction cost, choose to integrate vertically. As a result, we find firms producing intermediate products required in making of the final product. Suppose a car manufacturer enters into a contract with a producer of rear-view mirrors who makes them to the specifications of the car manufacturer. The car company might prefer to produce its rear-view mirror in house, for example by buying the mirror company. This would reduce time and resources spent over haggling over profits between parties to the transaction because decision would simply be taken by fiat.
Williamson’s theory can be tested against decision by companies to integrate parts of their supply chain. Several studies have shown, for instance, that if an electricity generator producer buys its coal from a nearby coal mine, who is the only supplier, then the electricity generator company tends to own the coal mine. Pricing of intra-firm transfer products between a parent company and its subsidiary or between divisions of a large company is termed transfer price.
A Firm corresponds to unified governance. It is a legal entity in whose name various transactions are consummated with other firms and with individuals. Firm’s governance structure needs to match to the characteristics of the transaction.
Transfer Pricing
A transfer price is the price one sub-unit (segment, department, division and so on) charges for a product or service supplied to another sub-unit of the same organization. The transfer price creates revenue for the selling sub-unit and purchase costs for the buying sub-unit, effecting each sub-units income. The product transferred between sub-units of an organization is called intermediate product. Transfer pricing methods are widely and ably discussed in Managerial Economics Text books and Cost Accounting Books for Managers.
Williamson discussed above, won the 2009 Nobel Economics prize jointly with Elinor Ostrom. Williamson borrows insights from Organizational Theory and Behavioural Economics and uses them in his theories of Firms and Organizations. Elinor Ostrom, a political scientist devoted her whole life for researches in Economic governance, especially relating to common property resources. Standard economic models predict that in the absence of clearly defined property rights, common property resources such as pastures and fisheries will be over exploited. Over grazing and over fishing will result. In her book on Governing Commons (1990) Ostrom argues that people using these common resources formulate rules and regulations of governance which work much better than Government regulations. Ostrom concludes that there are ways of solving collective action problems within the public sector as well as in the private sector. She suggests that we should learn from highly successful policies the best policies to follow as guidelines. Her researches on policy analysis in the future of good societies titled MUSE can be downloaded through the internet
(http://muse/hvoedu/gso/summary/ostrom.html)
Williamson and Ostrom have focused attention on transactions within firms, households and agencies. They have used economic analysis to explain these institutional arrangements and their governance.
Jean Tirol, a French Economist wins the Nobel Prize in 2014. While awarding the Noble Economist Prize to Tirol the award committee mentions is research on Market Power and regulation which helped Governments understand and regulate industries dominated by a small number of dominant firms are a single Monopoly. Left un-regulated, such markets often produced socially un-desirable results – prices higher than costs, or unproductive firms that survive by blocking entry of new and non productive funds. Tirol analyzed such market failures. His work has a strong bearing on how Governments should deal with mergers or Cartels and how they should regulate monopolies.
In his books Dynamic Models of Oligopoly, The Theory of Industrial Organization, The Theory of Incentives and Regulation and Procurement and in a series of articles Tirol has presented a general framework for regulatory policies for application to number of Industries ranging from Tele Communications and Banking.
To know more about Transaction Costs, read
We have presented above Williamsons' contributions on transactions costs Economics. Nobel Economists Holmstrom and Oliver Hart won the prize in 2016 for their "contributions to contract theory". We present below the citation of the press release of Noble Prize Awarding Committee.
Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.
Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.
In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information.
In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.
Homstrom and Hart, in their joint work compared the incentives to owners in pubic and private prisons, for example. In publicly owned prisons, managers might under invest in quality improving measures but private owners face a too strong an incentive to cut costs, leading to conditions for prisioners that are worse than those in pubic prisons.
To get an overview of the significant contributions of Nobel Economists – 2016 one may refer to the following articles.
Milton Friedman (1912-2006) Friedman served as professor of Economics at the university of Chicago for more than three decades and he was the leading figure of the “Chicago School of Monetary Economics.” Next to Keynes, Friedman had most influenced government policies in many countries. Friedman came to India as an advisor in 1955. Friedman championed the cause of Free Markets and he persuasively argued to free men from the shackles of government controls. He undertook this task as a crusader till his death in November, 2006. |
Chapter - 11
Monetary Economics
(Hayek, Friedman, Phelps, Tobin, Lucas, Sargent, Kydland, and Prescott)
Hayek
In the field of monetary theory Hayek has many works to his credit. They are: The pure theory of Capital, Prices and production, Monetary Theory and Trade Cycle and Interest and Investment.
His technical writings in Monetary Economics have not received much recognition and praise from his contemporary economists such as Keynes, Hicks and Milton Friedman. However, Hayek’s Monetary Over-investment theory is discussed widely and is being discussed even now in the context of Business Cycles.
Hayek propounded’ additional Credit theory of Trade cycle’. During phases of expansion Banks create Credit and such extension of credit lowers the Market rate of interest below the ‘Natural rate’ of interest. This makes producers to borrow more and invest more. Hayek tries to show how forced saving (credits expansion) changes the structure of production by an artificial increase in investment. This lengthens the process of production and leads to a dis-proportionality between Consumption and Investment, because the new money spent on investment becomes Consumers income and thereby results in increased demand for consumer goods. The rise of consumer goods prices and the consequent fall in real wages means a rise in the rate of profit in the consumer goods industries compared with capital goods production. A fall in real wages will encourage capitalists to substitute Labor for Capital, that is shorten the process of production. The Boom according to Hayek collapses because of the unwillingness of Banks to create credit any further. Investment can be sustained only by voluntary savings and reduced Consumption.
Hayek, rather than Keynes provides an explanation to the 2008 Recession, Carmen, Reinhart, Kenneth Rogoff Lawrence White and Hyman Minsky have argued that financial cycle led to economic volatility. There was evidence of low interest rates leading to financial booms and misallocation of resources. Long booms tended to result in excessive risk taking.
Hayek is a true Liberal. He attacked the trend towards Statism in his work, Road to Serfdom (1944) and the Constitution of Liberty.(1960) Milton Friedman regards Hayek “the Twentieth Century greatest Philosopher of Liberty”.
Milton Friedman
Friedman’s chief contribution is to Monetary Theory. Among his major works in Monetary theories are:
1) Studies in the Quantity Theory of Money and
2) Monetary History of United States (jointly authored with Anna Schwarz).
Friedman had many followers such as Modigliani, Tobin and others. All these persons are known as monetarists. They believe that money matters. Modigliani declares that “we are all monetarists now”.
In the 1960’s the controversy between Monetarists and the Keynesians is widely debated. Both these groups were represented as holding extreme views. Monetarists holding the view “that only money matters” and the Keynesians holding that “money does not matter at all” The bone of contention between the Monetarists and Keynesians is in specifying the precise relationship between money and income. Keynesians have argued that money is merely an indicator; it merely registers a change in income. Monetarists contend that money can be or should be target variable.
To make the points in the controversy clear, let us briefly review the quantity theory of money. Irving Fisher’s quantity theory is known as Equation of Exchange and it is given in equation (1)
(Eqn.1) MV = P.Y
Fisher assumed that velocity of money (V) is highly stable. According to him, money (M), determines nominal income, given by the product of price (P) and output (Y).
In Cambridge (England) economists, Marshal and Pigou stated the quantity theory as a Cash – Balance Equation, given in equation (2).
(Eqn.2) M = k.P.Y
Where k is the cash balance kept as a proportion of income.
Both the versions of the quantity theories of money discussed above are similar, as Velocity of money (V) is equal to 1/k by definition. Rewriting equation (1) we get equation (3)
(Eqn.3) M = P(Y/V)
Where V or 1/k are stable and constant.
Output (Y) is at a full employment level and is treated as constant. Hence, an increase in money supply causes an equi-proportional increase in prices.
While Fisher stressed on the demand for money for transactions purpose, the Cambridge economists emphasized on the demand for money as a store of value. Keynes, on the other hand, said that money is demanded for transaction purposes, precautionary purposes and speculative purposes. Keynes observed that the link between money and income is through interest rates. In a liquidity trap situation, in times of a recession investors do not demand money for investment even at low interest rates. This implies that the LM curve is horizontal and changes in the quantity of money do not shift the LM curve. In such cases, monetary policy will have no effect on either the interest rate or the level of income. This explains Keynes argument that money does not matter. Monetarists argue that when the LM curve is vertical, monetary policy has a maximal effect on income and fiscal policy has no effect on income. This explains the monetarists argument that ‘only money matters’. Monetarists use the framework of the quantity theories of money discussed above. The monetarists believe that the income velocity of money is regular, predictable and almost a constant. Hence, they argue that money supply is the main determinant of output. In course of time, both the monetarists and Keynesians gave up their extreme positions in the debate and began to be accommodative to other’s opinion.
In his re-formulation of Quantity theory, Friedman provided a framework for the modern Portfolio approach to the demand for Money. He begins by postulating that money like many other assets yields a form of service to the person who holds it.
Friedman makes the demand for money depend on the real rate of interest on financial assets, the rate of return on nominal money, which is taken to be the rate of change of Price Level, P/P, the real income, Y, the ratio of non-human to human Capital, W and a taste variable, u . Friedman’s demand function for money is:
(Eqn.3)