Unit 6: The Firm and its Employees
Firms coordinate work through a structured hierarchy where owners and
managers make decisions and direct employees to implement them.
Unlike spontaneous groups, firms are organized entities with clear
decision-making processes and authority. Owners, through a board of
directors, determine long-term strategies, which managers then
operationalize by assigning tasks to workers. However, the flow of
relevant information within this hierarchy is imperfect, leading to
challenges in fully executing directives. This is illustrated by the green
arrows which represent asymmetric flows of information; they are
dashed lines because workers often know things that managers do not,
Figure 6.1: The firm’s actors and its decision-
making and information structures.
and managers know things that owners do not.
How Interactions Take Place: Firms versus Markets:
This structure contrasts sharply with market interactions, where decisions are decentralized, and transactions
between buyers and sellers are voluntary. In markets, buyers and sellers interact based on price mechanisms,
whereas within firms, power is concentrated in the hands of owners and managers, and orders are mandatory.
Ronald Coase highlighted that firms function like mini centrally planned economies, where decisions are made top-
down, unlike in market economies where the price mechanism dominates.
Contracts and Relationships: Figure 6.2: Distribution of job tenure, 2021.
Employment contracts, distinct from market contracts, temporarily
transfer authority over workers’ activities to employers. Unlike product
sales, where ownership is permanently transferred, employment
involves a long-term relationship that is often incomplete, as not all
aspects of the worker's role can be fully defined or enforced. This leads
to unique challenges in managing labour within firms, compared to the
straightforward nature of product transactions in markets.
The Gap Between Firm Ownership and Control:
Within a firm, owners, managers, and employees share a common interest in the firm's success but often have
conflicting interests over how to distribute the profits generated. While profits legally belong to the owners, who are
the residual claimants (the person who receives the income left over from a firm or other project after the payment
of all contractual costs), employees and managers are compensated through wages and salaries, not directly from
profits. This creates potential conflicts, particularly in large corporations where ownership and management are
separated.
Owners, who may not be involved in day-to-day operations, rely on managers to make strategic decisions that
maximize profits. However, managers, who do not directly benefit from the residual profits, may prioritize their own
interests, such as higher salaries or perks, over those of the shareholders. Shares are financial assets that can be
bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a
right to receive a corresponding share of the firm’s profit. This divergence of interests, noted by Adam Smith as early
as the eighteenth century, reflects the challenges of ensuring that managers act in the best interests of the owners.
, To align managers' interests with those of the owners, firms often tie managerial compensation to the company's
performance, such as share prices. Additionally, boards of directors, representing the shareholders, are tasked with
monitoring management and have the authority to dismiss underperforming managers. However, the large and
diverse nature of shareholders often leads to a free-rider problem, where individual shareholders enjoy the benefits
of the firm’s success, yet do not actively participate in governance, relying instead on others to protect their
interests.
Finding Jobs and Filling Vacancies:
Finding work can be a challenging process, especially for those with limited education or resources. One approach,
common in many countries, involves joining a pool of day labourers who gather in specific locations, hoping to be
hired for short-term, often low-paying jobs. This precarious type of employment is usually a last resort for workers
who have few other options, and while it benefits employers with low costs, it typically results in low productivity
and poor job matches.
Unlike markets for goods, where buyers and sellers interact without concern for the other party's identity, labour
markets function as matching markets. In these markets, both employers and workers, who have their own
characteristics, care deeply about finding the right match. A good match benefits both sides by allowing workers to
develop firm-specific skills and relationships, which increase their productivity and job satisfaction. This also reduces
the costs and disruptions associated with high turnover for employers.
Economist Oliver Williamson highlighted that these skills and relationships, known as relationship-specific or firm-
specific assets (its only value is within that economic relationship), lose their value if the employment relationship
ends. For both workers and employers, maintaining a good match is crucial, as losing it can result in significant costs,
such as the loss of social networks, job-specific knowledge, and the need for relocation.
Employment Flows: Match Creation and Destruction
The labour market functions as a dynamic system where
matches between workers and jobs are continuously formed
and dissolved. When an unemployed worker meets a firm with
a vacant position, and both parties agree on the terms of
employment, a match is created, adding to the pool of
employed workers and filled jobs. This employment relationship
lasts until one party decides to end it—either the worker leaves
for another job, exits the labour market, or the firm terminates
the contract due to performance issues or a lack of need for the Figure 6.3: Labour market flows: workers and jobs.
role.
When a match is broken, the worker and the firm re-enter the labour market, joining the pools of unemployed
workers and vacant jobs, respectively. They then begin the search for new matches, contributing to the ongoing flow
of recruitment, job changes, and job terminations within the labour market. This continuous process highlights the
constant movement and adjustment within the labour market as workers and employers seek strong, long-term
matches that benefit both parties.
Managing Hiring and Quitting:
In the labour market, firms and workers typically connect through job advertisements and applications. Employers
offer contracts to candidates who meet their needs, and workers decide to accept or reject these offers based on
factors like the wage. While some wages are negotiated, many are set by the employer. Workers' decisions are
influenced by their reservation wage—the minimum wage they are willing to accept, considering alternatives like
unemployment benefits or other job opportunities.
