UNIT 6: THE FIRM: OWNERS, MANAGERS AND EMPLOYEES
FIRM: an organization which:
- pays wages (w) to employ people (L)
- purchases inputs (K, M, Hc)
- to produce and market goods and services (Q), with the intention to make a profit (pi)
Owners decide long-term strategies, Board of Directors directs them to the managers.
Managers match workers to the tasks required to implement to strategy.
While executing, flows of information are imperfect (asymmetric) → need for contracts
Contract: A legal document that specifies a set of actions that parties must undertake:
- contracts for products sold in markets permanently transfer ownership of the good
from the seller to the buyer.
Contracts are typically incomplete? Why:
1. The manager does not know precisely how the employee will contribute
2. Worker effort ii unobservable.
Incomplete contract: a contract that cannot enforce everything the firm and the worker care
about (e.g. effort, attitude, working hours, emergencies)
How to induce higher effort from workers?
One option: pay the lowest possible age (the one which keeps them indifferent between
having a job and living on welfare)
A more realistic option: pay the reservation wage + an employment rent
Employment rent: what the job pays – the fallback option (the welfare benefit)
Why creating the employment rent (ER) for workers is important to managers:
1. The worker is more likely to stay in the firm
2. The threat to fire a low-effort worker is credible
,UNIT 7: THE FIRM AND ITS CUSTOMERS
Growth Strategies:
- Low profit margins, ever increasing scale: Tesco, Amazon
- High profit margins, exclusivity: Apple, luxury brands
How do firms maximise their profits?
Constrained optimization: A decision-maker chooses the values of one+ variables
1. To achieve an objective
2. Subject to a constraint that determines the feasible set.
How does the firm determine its price?
1. Know your demand (feasibility constraint)
2. Maximise your value function (profit) given your feasibility constraint (demand)
Consumer responsiveness to price changes determines profitability.
Price elasticity of demand (ε): the percentage change of quantity demanded of good X as a
response to a 1-percentage point change in the price of the same good.
Economies of scale: When a firm grows, its average costs decline.
1. Technological advantages: Large-scale production uses fewer inputs per unit of
output (increasing returns to scale.)
2. Cost advantages:
a. Fixed costs are distributed across larger output:
i. Advertising
ii. Research and development
b. Bargaining power over input costs
3. Demand advantages: network goods (Facebook + Instagram; Google + Android;
windows + explorer)
Diseconomies of scale: when a firm becomes too large, average costs start increasing.
, UNIT 8: (PART 1) SUPPLY AND DEMAND: PRICE TAKING AND
COMPETITIVE MARKETS
US civil war (1861): export of US cotton to England fell by 75% ⇒:
1. A large excess demand for cotton in England;
2. Cotton prices in England increased six-fold;
3. Consumption of cotton by factories was cut by 50%;
4. Thousands of workers in cotton mills out of work;
5. Mill owners substituted Indian cotton for US cotton;
6. Rising demand for Indian cotton raised the cotton price in
7. India; Indian farmers switched to cotton, raising its supply. Similar
8. trends in Brazil and Egypt.
9. Indian cotton different from the US cotton → new machines
10. to process it in high demand.
11. ⇒ Prices are powerful signals for consumers, firms; technology.
Equilibrium in a market for good X is: Price Px∗ and quantity Qx∗, such that simultaneously:
1. consumers maximize utility, given their budget constraint
2. firms maximize profit, given their demand constraint
3. markets clear.
is self-perpetuating, unless a change is introduced.
Competitive equilibrium- An equilibrium in which all buyers and sellers are price-takers.
To be a price taker, a firm needs to be:
1. small relative to the size of the market
2. sell an identical (homogeneous) product to the rest of the market.
Willingness to pay (WTP) An indicator of how much a person values a good, measured by
the maximum amount he or she would pay to acquire a unit of the good.
Reservation price- the lowest price at which someone is willing to sell a good (keeping the
good is the potential seller’s reservation
A price-taking firm maximizes profit by choosing a quantity where the marginal cost is equal
to the market price (MC = P*) and selling at the market price P*.
We can think of the total surplus as a measure of the welfare of society as a whole (provided
that the tax revenue is used for the benefit of society). So there is a second reason for a
government that cares about welfare to prefer taxing goods with low elasticity of demand—
the loss of total surplus will be lower.
FIRM: an organization which:
- pays wages (w) to employ people (L)
- purchases inputs (K, M, Hc)
- to produce and market goods and services (Q), with the intention to make a profit (pi)
Owners decide long-term strategies, Board of Directors directs them to the managers.
Managers match workers to the tasks required to implement to strategy.
While executing, flows of information are imperfect (asymmetric) → need for contracts
Contract: A legal document that specifies a set of actions that parties must undertake:
- contracts for products sold in markets permanently transfer ownership of the good
from the seller to the buyer.
Contracts are typically incomplete? Why:
1. The manager does not know precisely how the employee will contribute
2. Worker effort ii unobservable.
Incomplete contract: a contract that cannot enforce everything the firm and the worker care
about (e.g. effort, attitude, working hours, emergencies)
How to induce higher effort from workers?
One option: pay the lowest possible age (the one which keeps them indifferent between
having a job and living on welfare)
A more realistic option: pay the reservation wage + an employment rent
Employment rent: what the job pays – the fallback option (the welfare benefit)
Why creating the employment rent (ER) for workers is important to managers:
1. The worker is more likely to stay in the firm
2. The threat to fire a low-effort worker is credible
,UNIT 7: THE FIRM AND ITS CUSTOMERS
Growth Strategies:
- Low profit margins, ever increasing scale: Tesco, Amazon
- High profit margins, exclusivity: Apple, luxury brands
How do firms maximise their profits?
Constrained optimization: A decision-maker chooses the values of one+ variables
1. To achieve an objective
2. Subject to a constraint that determines the feasible set.
How does the firm determine its price?
1. Know your demand (feasibility constraint)
2. Maximise your value function (profit) given your feasibility constraint (demand)
Consumer responsiveness to price changes determines profitability.
Price elasticity of demand (ε): the percentage change of quantity demanded of good X as a
response to a 1-percentage point change in the price of the same good.
Economies of scale: When a firm grows, its average costs decline.
1. Technological advantages: Large-scale production uses fewer inputs per unit of
output (increasing returns to scale.)
2. Cost advantages:
a. Fixed costs are distributed across larger output:
i. Advertising
ii. Research and development
b. Bargaining power over input costs
3. Demand advantages: network goods (Facebook + Instagram; Google + Android;
windows + explorer)
Diseconomies of scale: when a firm becomes too large, average costs start increasing.
, UNIT 8: (PART 1) SUPPLY AND DEMAND: PRICE TAKING AND
COMPETITIVE MARKETS
US civil war (1861): export of US cotton to England fell by 75% ⇒:
1. A large excess demand for cotton in England;
2. Cotton prices in England increased six-fold;
3. Consumption of cotton by factories was cut by 50%;
4. Thousands of workers in cotton mills out of work;
5. Mill owners substituted Indian cotton for US cotton;
6. Rising demand for Indian cotton raised the cotton price in
7. India; Indian farmers switched to cotton, raising its supply. Similar
8. trends in Brazil and Egypt.
9. Indian cotton different from the US cotton → new machines
10. to process it in high demand.
11. ⇒ Prices are powerful signals for consumers, firms; technology.
Equilibrium in a market for good X is: Price Px∗ and quantity Qx∗, such that simultaneously:
1. consumers maximize utility, given their budget constraint
2. firms maximize profit, given their demand constraint
3. markets clear.
is self-perpetuating, unless a change is introduced.
Competitive equilibrium- An equilibrium in which all buyers and sellers are price-takers.
To be a price taker, a firm needs to be:
1. small relative to the size of the market
2. sell an identical (homogeneous) product to the rest of the market.
Willingness to pay (WTP) An indicator of how much a person values a good, measured by
the maximum amount he or she would pay to acquire a unit of the good.
Reservation price- the lowest price at which someone is willing to sell a good (keeping the
good is the potential seller’s reservation
A price-taking firm maximizes profit by choosing a quantity where the marginal cost is equal
to the market price (MC = P*) and selling at the market price P*.
We can think of the total surplus as a measure of the welfare of society as a whole (provided
that the tax revenue is used for the benefit of society). So there is a second reason for a
government that cares about welfare to prefer taxing goods with low elasticity of demand—
the loss of total surplus will be lower.
