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Chapter 6 - Coggle Diagram
Chapter 6
Unit 1
The importance of work and firms in the economy:
-Work is how people produce their livelihoods. In deciding how much time to spend working, people face a trade-off between free time and the goods that they can produce, or the wage income that they can earn
-Production, wages, and living standards have grown through the innovation and adoption of new technologies by firms
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Firms make profits by finding the supplier that can provide inputs at the lowest cost, whether the input is a component or labour, wherever in the world that supplier may be located
The way that labour is coordinated within firms is different to coordination through markets:
-Firms represent a concentration of economic power
-Markets are characterised by a decentralization of power
Firms do not pay the lowest wages possible. They set wages so that employees earn economic rents, to motivate them to work effectively and stay with the firm
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Incomplete contracts arise when important information, such as the employees effort, is asymmetric or non-verifiable
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The firm is an actor in the capitalist economy, and a stage on which interactions among the firms employees, managers, and owners are played out
Different types of contracts:
-Sale contract - transfer of ownership
-Rental contract - gives tenant a limited set of rights
-Wage labour contract - An employee gives the employer the right to direct him/her to be at work at specific times, and to accept the authority of the employer over the use of his/her time while at work
Unit 2
Managers are not residual claimants, neither are employees
The senior management of a firm is also responsible for deciding hoe much of the firms profits are distributed to shareholders in the form of dividends, and how much is retained to finance growth
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When managers decide on the use of other peoples funds, this is referred to as the separation of ownership and control
The owners take whatever remains after revenues are used to pay employees, managers, suppliers , creditors and taxes
There are two ways that owners can incentivise managers to server their interests:
-They can structure contracts so that managerial compensation depends on the performance of the company's share price
-The firms board of directors which represent the firms shareholders and typically has a substantial share in the firm can monitor the managers performance
Unit 3
A firm cannot write and enforceable employment contract that specifies the exact tasks an employee has to perform in order to get paid. This is for 3 reasons:
-When the firm writes a contract for the employment of a worker, it cannot know exactly what it will need the employee to do, because this will be determined by unforeseen events
-It would be impractical or too costly for the firm to observe exactly how much effort each employee makes in doing the job
-Even if the firm somehow acquired this information, it could not be the basis of an enforceable contract
Piece-rate-work provides the employee with an incentive to exert effort, because employees take home more pay if the make more garments
A firms profits depend on 3 things:
-Costs of acquiring the inputs necessary for the production process
-Output
-Sales revenues received from selling goods/services
Unit 7
Diagram joins together a set of points that have the same ration of effort to wages, e / w
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If she provides e units of effort per hour, the cost of a unit of effort is w / e
To minimize costs, the employer will seek to reach the steepest isocost line for effort, where the cost of a unit of effort is lowest. But because he cannot dictate the level of effort, he has to pick some point on Maria's best response curve
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The best he can do is to set the wage at $12 on the isocost line that is a tangent to Maria's best response curve
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The employer will choose point A, offering a wage of $12 per hour to hire Maria, who will exert effort of 0.5
To maximize profits, firms want to minimize the costs of production. They want to pay the lowest possible price for inputs
The employer minimizes costs and maximizes profit at the point where his MRS (slope of his indifference curve or isocost line) equals the MRT (slope of the best response curve, which is his feasible frontier)
The fact that the best response curve slopes upwards means that employers face a trade-off. They can get more effort only by paying higher wages
When wages are set by the employer in this manner they are sometimes called efficiency wages, because the employer is recognizing that what matters for profits is e / w the efficiency units per dollar of wage costs, rather than how much an hour of work costs
Maria chooses how hard she works. The best the owner can do is to determine the conditions under which she makes that choice
In equilibrium, both wages and involuntary employment have to be high enough to ensure that there is enough employment rent for workers to put in effort
Unit 8
When unemployment is high, workers who lose their jobs can expect a longer spell of unemployment. Unemployment benefits are limited, so the longer the expected spell of unemployment the lower the level of the unemployment benefits per hour of lost work
An increase in the duration of a spell of unemployment has two effects:
-It reduces the reservation wage
-It extends the period of lost work time
The position of the best response curve depends on:
-The utility of the things that can be bought with the wage
-The disutility of effort
-The reservation wage
-The probability of getting fired when working at each effort level
A rightward shift of the employee's best response function favors employees, who will put in less effort for any given wage, while a leftward shift favour owners who will acquire the effort of their employees at a lower cost, raising profits
Changes in economic conditions or public policies can shift the entire best response curve , moving it to the right or the left
Unit 9
Main differences between conventional firms and worker owned cooperatives are:
- Worker owned cooperatives are hierarchically organized like conventional firms, but the directives issued from the top of the hierarchy come from people who owe their jobs to the worker owners
- The cooperatives need fewer supervisors and other management personnel to ensure that the worker owners work hard an well
- Reduced need for the supervision of workers is among the reasons that worker owned cooperatives produce at least as much per hour than their conventional counterparts
- Inequalities in wages and salaries within the company are also typically less in worker owned cooperatives than in conventional firms
- Worker owned cooperatives tend not to lay off workers when the economy goes into recession offering worker owners some kind of insurance
Unit 6
We will assume that Maria's reservation wage is $6. Even if she put in no work whatsoever her job at a $6 wage would be no better than being without work
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If Maria chooses her work effort as a best response to the employer's offer, and the employer chooses the wage that maximizes his profit given that Maria responds the way she does, their strategies are a nash equilibrium
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Maria's payoff is her net valuation of the wage she receives, taking into account the effort she has expended
As the level of effort approaches the maximum possible level, the disutility becomes greater
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The best response function shows how paying higher wages can elicit higher effort, but with diminishing marginal returns
On the stage of the firm, the cost of characters is just the owner and a single worker, Maria. The game is sequential. Here is the order of play:
1) The employer chooses a wage
2) Maria chooses a level of work effort
The higher the initial wage, the smaller the increase in effort and output the employer gets from an extra $1 per hour in wages
When the cost of job loss (the employment rent) is large, workers will be willing to work harder in order to reduce the likelihood of losing the job
The best response curve is the frontier of the feasible set of combinations of wages and effort the firm can get form its employees, and the slope of the frontier is the marginal rate of transformation (MRT) of wages into effort
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Unit 5
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Suppose that if she loses her job she can expect to remain unemployed for 44 weeks before finding another job
Suppose she spends half of her working time actually working. We present this as an effort level of 0.5. Working this hard is equivalent to a cost of $2 per hour to Maria
net utility per hour = wage - disutility of effort per hour
=$12-$2
=$10
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Using the concept of utility we can say that Maria's utility is increased by the goods and services she can buy with her wage, but reduced by the unpleasantness of going to work and working hard all day - the disutility of work
Let us suppose that while Maria remains unemployed, she will receive a benefit equivalent to being paid $6 an hour for a 35 hour week. This is her reservation wage, so she would be indifferent between having a job that paid $6 an hour and not working
We consider Maria, an employee earning $12 an hour for a 35 hour working week. To determine her economic rent, we need to think how she would evaluate tow aspects of her job:
-The pay that she gets
-How hard she works
Employment rent per hour = wage - reservation wage - disutility of effort
=wage - unemployment benefit - disutility of effort
=$12 - $6 - $2
=$4
Total employment rent = employment rent per hour x expected hours of lost work time
=$4 x 1540
=$6 160
If Maria's eligibility for unemployment benefits of $6 lasted only for 13 weeks, her reservation wage would not be $6 - she would not be indifferent between a job that paid $6 an hour and unemployment
The employment rent would be higher and her reservation wage would be lower, because the average level of benefits she could expect over the 44 week period of unemployment would be much less than $6
Unit 4
An economic rent measures the value of a situation compared to what you would get if the current situation were no longer possible
To calculate employment rent we need to weigh up all the benefits and costs of working compared with being unemployed and searching for another job
Employment rents can benefit owners and managers in two ways:
-The employee is more likely to stay with the firm
-They can threaten to fire the worker
There are some costs of working, such as:
-The disutility of work: employees must spend time doing things that they would prefer not to do
-The cost of travelling to work everyday
Reasons why people do a good job / work hard:
-Doing a good job is its own reward, and doing anything else would contradict their work ethic
-Feelings of responsibility for other employees or for ones employer may provide strong work motivation
-Hard work is a way to reciprocate a feeling of gratitude to the employer for providing a job with good working conditions
-Firms identify teams of workers whose output is readily measured and pay a good benefit to the whole group that is divided among team members
-The fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security
There are many benefits, which would be lost if you lost your job:
-Wage income
-Firm-specific assets: workplace friends, proximity of the workplace to your present home
-Medical insurance
-The social status of being employed
Unit 10
There are several reasons for the absence of a complete contract:
-Information is not vertifiable
-Time and uncertainty
-Measurement
-Absence of judiciary
-Preferences
Many contractual relationships can be modelled in the same way, as a game between two players whom we call the principal and the agent, who face a conflict of interest. These are known as principal agent problems
There are many other ways in which we interact without a complete contract:
- People and banks lend money in return for a promise to repay the full amount plus the stipulated interests. But this may be unenforceable if the borrower is unable to repay.
- Owners of firms would like managers to maximize the value of the owners assets, but managers have their own objectives and managerial contracts often fall short of an enforceable requirement to maximize the owners wealth
- The contracts signed by tenants renting apartments may include clauses requiring that they maintain the values of the property. But aside from gross neglect, the liability for not maintaining the property is unenforceable
- Insurance contracts require that the people who purchase insurance should behave prudently and try not to take risks
- Families devote a sizeable fraction of their budgets to purchasing educational and health services, the quality of which is rarely specified in a contract
- Parents care for children with the hope, but no contractual assurance, that their children will reciprocate when the parents are old and unable to work
A hidden action problem occurs when there is a conflict of interest between the principal and the agent over some action that my be taken by the agent, and this action cannot be subjected to a complete contract. In these problems, information about the action is either asymmetric (the agent knows what action is taken, but the principal doesnt) or unverifiable (it cannot be used by a court to enforce a contract)
Unit 11
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Principal agent models help us understand how firms work by identifying the consequences of the conflicts of interest between the actors when these cannot be resolved by complete contracts