Read from book

• sections 6.1 to 6.7 and the lecture

Firms, markets, and the division of labor

• In a capitalist economy division of labor is coordinated in two major ways
  • Through firms
  • Markets

1. Firms: represent a concentration of economic power. The power is placed in hands of owners and managers who often make decisions or place orders (a form of command) that needs to be carried out. Owners or managers direct the employees. For instance, owners and managers of Walmart direct activities of about 2.2 million employees. Firms are involved in decision making process; as it is composed of individuals, needs and desires may give rise to conflict. The power held by a certain group of people (mainly owners and managers) are distinct, which defines relationship within a firm. Ronald Coase, an economist writes: -If a workman moves from department Y to department X, he does not go because of a change in relative prices but because he is ordered to do so … the distinguishing mark of the firm is the suppression of the price mechanism. (‘The Nature of the Firm’, 1937)

2. Markets: are characterized by decentralization of power. For instance, a consumer’s decision of purchasing something is voluntary – she is not ordered to purchase. Accordingly, a seller can reject to sell something to the consumer.

Contracts and relationships - Differences between firms and markets can be relized how contracts play role in setting relationships in the market and within a firm. - In market: A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use. Contracts in the market permanently transfer ownership from one party to another. - wage labor contract: between employer and employee which provides employer with a right to direct (order) the employee during the time at work. There is only a temporary transfer of ownership in this case – a full transfer of ownership would be slavery.

Question

1. Which of the following statements is true?

• A labour contract transfers ownership of the employee from the employee to the employer.
• The office where the employee works is a relation-specific asset, because the employee cannot use it after leaving the firm.
• In a labour contract, one side of the contract has the power to issue orders to the other side, but this power is absent from a sale contract.
• A firm is a structure that involves decentralization of power to the employees.

6.2 Other people’s money: The separation of ownership and control

• Firms can have separate owners and people who direct other people directly (managers)
• Owners take all the revenue that is left after subtracting wages to employees, managers, suppliers, creditors, and taxes.
  • Profit is also called the residuals (remaining), hence, owners are called residual claimants
• The objective of the owners is to maximize profit. This can be if employees start doing their job properly, but the employees might not share the exact motivation
  • conflict of interest
• A large corporation is an example of a firm that sells shares to raise capital. The people who buy the shares provide money to firms – they become owners.
  • This money is used by the managers to make decisions. When managers decide on the use of other people’s funds, this is referred to as the separation of ownership and control.

Question

2. Which of the following statements about the separation of ownership and control is true?

• When the ownership and control of a firm is separated, the managers become the residual claimants.
• Managers always work to maximize the firm’s profit.
• One way to address the problem associated with the separation of ownership and control is to pay the managers a salary that depends on the performance of the firm’s share price.
• It is effective for shareholders to monitor the performance of the management, in a firm owned by a large number of shareholders.

Other people’s labor

• The firm not only uses other people’s money but also use other people’s labor
  • employee’s effort
• Note that labor is an input in production process.
• If the firm’s objective is to maximize profit, this is same as saying minimize cost (given that revenue is fixed).
  • profit = revenue - cost
• How could the firm provide an incentive to do the job well, even though the worker is paid for time and not output?

Question

3. Which of the following are reasons why employment contracts are incomplete?

• The firm cannot contract an employee not to leave.
• The firm cannot specify every eventuality in a contract.
• The firm is unable to observe exactly how an employee is fulfilling the contract.
• The contract is unfinished.

Determinants of the employment rent

• employment rent: The difference between wage and disutility acquired from working.

• Let’s use the concept of utility (Unit 3) to explain reservation wage.
  • \(net \;utility = wage - disutility \;of \;effort \;per \;hour\)
• Maria makes $12 per hour, works 35 hours per week, and she spends half of her time working hard (effort level = 0.5). This effort level has a cost, the cost of disutility (say $2 in this context).
  • \(Maria's \;net \;utility = \$12-\$2=\$10\)
  • This is Maria’s employment rent per hour

Figure 1. Shows employment rent (per week)

• Figure 1 shows the employment rent per week \(=35*\$(12-2)=350\)

• Similarly, calculate total employment rent is \[\begin{align*} \text{total employment rent} &= \text{employment rent per hour} \times \text{expected lost hours of work} \\ &= \text{\$10 per hour} \times \text{1,540 hours} \\ &= \$15,400 \end{align*}\]

Determinants of the employment rent and reservation wage

• Say, Maria is paid $6 when unemployed. This can be through government assistance. Maria would not even consider working until her was is $6.
  • Here, $6 is the lowest wage she would consider before deciding to work. This is called her reservation wage.
• The reservation wage of $6 changes the calculation of employment rent
  

  Figure 2. Shows employment rent with reservation wage of $6 (per week)

  \[\begin{align*} \text{employment rent per hour} &= \text{wage} - \text{reservation wage} - \text{disutility of effort} \\ &= \text{wage} - \text{unemployment benefit} - \text{disutility of effort} \\ &= \$12 - \$6 - \$2 \\ &= \$4 \end{align*}\]

\[\begin{align*} \text{employment rent per hour} &= \text{wage} - \text{reservation wage} - \text{disutility of effort} \\ &= \text{wage} - \text{unemployment benefit} - \text{disutility of effort} \\ &= \$12 - \$6 - \$2 \\ &= \$4 \end{align*}\]

Question

4. Maria earns $12 per hour in her current job and works 35 hours a week. Her disutility of effort is equivalent to a cost of $2 per hour of work. If she loses her job, she will receive unemployment benefit equivalent to $6 per hour. Additionally, being unemployed has psychological and social costs equivalent to $1 per hour. Then:

• The employment rent per hour is $3.
• Maria’s reservation wage is $6 per hour.
• Maria’s employment rent if she can get another job with the same wage rate after 44 weeks of being unemployed is $6,160.
• Maria’s employment rent if she can only get a job at a lower wage rate after 44 weeks of being unemployed is more than $7,700.

6.6 Work and wages: The labor discipline model

• when employment rent is high (cost of job loss), worker will be willing to work harder.
  • can increase employment rent by increasing wages; provides incentive to work harder

• Let’s represent the social interaction (between managers and employees) in the firm from a game theory standpoint

• we have
  • a list of the players
  • the strategies they can adopt
  • the order in which the players choose their actions
  • what the players know when they choose their actions
  • the outcomes for each of the players (their payoffs) for all of the strategies that may be chosen

• Greater Maria’s effort, higher the profit.

• Maria chooses her work effort as the best response to employer’s wage offer such that it maximizes his profit given that Maria responds to a set wage the way she does.
  • This set of strategies are called the Nash equlibrium
• Now we have a model where employer and employee interact to form a set wage offer. The game operates as follows:
  1. the employer chooses a wage
  2. Maria chooses a level of work effort

The employee’s best response - Assume that Maria’s reservation wage is $6. Effort has a cost for Maria. She can choose her effort between 0 (total slacking off) and 1 (hard at work). - Let’s start with wage offer of $6. Maria gets $6 even if she is not working. So if the offer is $6, her choice of effort will be 0.

• What if wages are higher?
  • Maria’s higher effort will increase the likelihood of keeping her job, increases employment rent, but also increase disutility. So she will try and balance benefit and cost.
• We can plot Maria’s best response function – a combination of wage offer and the level of effort picked (dependent on the wage offer).

Figure 3. Maria’s best response

• Notice that the slope of the best response is steeper at first and flattens out as wage increase. This means that at initial level of wage, a slight increase in wage offer can induce a high level of effort, but if the wage is high already, increasing it further does very little in terms of effort.

• Question

1. Figure 3 above depicted Maria’s best response curve when the expected duration of unemployment was 44 weeks. Which of the following statements is correct?
   • If the expected unemployment duration increased to 50 weeks, Maria’s best response to a wage of $12 would be an effort level above 0.5.
   • If the unemployment benefit was reduced, then Maria’s reservation wage would be higher than $6.
   • Over the range of wages shown in the figure, Maria would never exert the maximum possible effort per hour.
   • Increasing effort from 0.5 to 0.6 requires a bigger wage increase than increasing effort from 0.8 to 0.9.

Wages, effort, and profits in the labor discipline model

• After seeing Maria’s best response, higher wage offer will increase her effort, which can then increase productivity (leading to increase in profit).
• From the owner’s perspective, there is a trade-off here – can only increase effort by increasing wage.
  • But note that firms want to minimize cost (pay the lowest amount as possible). But this does not mean that the employer pays $6. What would happen if the wage offer is $6?
• \(w\) is the wage offer; \(e\) is the units of effort (unit of effort matters for production rather than hours of work)
  • note that cost to the employer in terms of wage is \(w/e\). For example if \(e=0.5\), cost in terms of wage is \(2w\), because Maria slacks off half the time.

• Employer’s objective Find wage and effort combination, \(w^{*}\) and \(e^{*}\), that minimizes \(w/e\). Another way to say the same thing is that the employer should maximize the number of units of effort (sometimes called efficiency units) that he gets per dollar of wage cost, e/w.

• Let’s take a look at the employer’s isocost
  

  Figure 4. The isocost line

• The isocost line maintains the ratio of \(e/w\) as constant, or it assures that effort per dollor of wage is constant throughout the line. It captures the postive relationship between wage and effort; hence, upward sloping.
  

  Figure 5. The isocost line and Maria’s best response curve together

• Let’s put Maria’s best response and isocost lines with different slopes together. Then there will be one isocost line, that will be tangential to the point on the worker’s best response curve.
  • This is point A, where wage offer is \(12\). Here, Maria exerts effort of level 0.5.

Question

5. Figure 5 depicts the efficiency wage equilibrium of a worker and a firm. According to this figure:

• Along the isocost line tangent to the best response curve, doubling of the per-hour effort from 0.45 to 0.90 would lead to an increased profit for the firm.
• The slope of each isocost line is the number of units of effort per dollar.
• At the equilibrium point, the marginal rate of transformation on the isocost line equals the marginal rate of substitution on the worker’s best response curve.
• Points C and A both represent Nash equilibria because they are on the best response curve.