Global economyInnovation Show
How the interactions among the firm’s owners, managers, and employees influence wages, work, and profits, and how this affects the entire economy
Apple’s iPhone and iPad are iconic American hi-tech products, yet neither is assembled in the US. Until 2011 a single company, Foxconn, produced every iPhone and iPad in factories in China, mainly so that Apple could take advantage of lower costs, including wages. The components of the iPhone and iPad for the most part do not come from China, but are sourced from around the world. Components such as the flash memory, display module, and touch screen are made by a number of different companies including Toshiba and Sharp in Japan. The microprocessor is made by Samsung in South Korea and other components, by Infineon in Germany. Like other firms, Apple makes 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 cost of assembling the components into the final product in China is small—making up only 4% of the total cost—compared to the cost of components sourced from high-wage economies such as Germany and Japan. Almost half of Apple’s employees in the US sell Apple products rather than making them, while firms compete on a global scale to win the lucrative business of supplying Apple with its components. The cost of producing the iPhone is far lower than the price Apple charges: in 2016, a 32Gb iPhone 7 cost $224.80 to manufacture. Its price in the US was $649. offshoringThe relocation of part of a firm’s activities outside of the national boundaries in which it operates. It can take place within a multinational company or may involve outsourcing production to other firms.Apple is not alone in outsourcing (or offshoring) production to countries that are not the main market for the goods produced. In most manufacturing industries, firms based in rich countries have transferred a significant proportion of production, which was previously done by local employees, to poorer countries where wages are lower. But Apple and other firms are looking for more than cheap labour. Wages in some of Apple’s source countries such as Germany are higher than in the US. Other industries, particularly garment manufacturing, have relocated primarily to low-wage economies. More than 97% of apparel and 98% of footwear sold in the US by American brands and retailers is made overseas. China, Bangladesh, Cambodia, Indonesia, and Vietnam are now among the world’s main exporters of textiles and clothing. At the time of the Industrial Revolution, the world’s largest exporter was Britain. Also, in developing countries, additional business costs such as health and safety rules are far lower, and environmental regulations are often less strict. firmEconomic organization in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.Apple, Samsung, and Toshiba are business organizations called firms. Not everyone is employed in a firm. For example, many farmers, carpenters, software developers or personal trainers work independently, as neither employee nor employer. While some people work for governments and not-for-profit organizations, the majority of people in rich nations make their living by working in a firm. Firms are major actors in the economy and we will use this and the next unit to explain how they work. A firm is often referred to as if it were a person: we talk about ‘the price Apple charges’. But while firms are actors—and in some legal systems are treated as if they were individuals—firms are also the stage on which the people who make up the firm (employees, managers, and owners) act out their sometimes common but sometimes competing interests. In our ‘Economist in action’ video Richard Freeman, an economist who specializes in labour markets, explains some of the consequences of outsourcing for these actors. To understand the firm, we will model how employers set wages and employees respond. We have already seen, in earlier units, the importance of work, and firms, in the economy:
We illustrated each of these conclusions using models that illuminate some aspects of the economy, while setting aside others. In Unit 2, we did not consider how the length of the working day was determined while the economy was growing. In Unit 3, we did not model how the wage or the marginal rate of transformation of free time into goods was determined when we analysed a decision on working hours. In Unit 2 we told a story of conflicting interests over wages, but we did not model strategic interaction and bargaining until Units 4 and 5. And in Unit 5 we used the story of just two (imaginary) people called Bruno and Angela to model how bargaining may affect the Pareto efficiency and fairness of allocations. In this unit, we study how, in the modern capitalist economy, the coordination of labour takes place within firms. We model how wages are determined when there are conflicts of interest between employers and employees, and look at what this means for the sharing of the mutual gains that arise from cooperation in a firm. In Unit 7, we look at the firm as an actor in its relationship with other firms and with its customers. 6.1 Firms, markets, and the division of labourThe economy is made up of people doing different things, for example producing Apple display modules or making clothing for export. Producing display modules also involves many distinct tasks, done by different employees within Toshiba or Sharp, the companies that make them for Apple. division of labourThe specialization of producers to carry out different tasks in the production process. Also known as: specialization.Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways: firms and markets. Among the institutions of modern capitalist economies, the firm rivals the government in importance. John Micklethwait and Adrian Wooldridge explain how this happened. John Micklethwait and Adrian Wooldridge. 2003. The Company: A Short History of a Revolutionary Idea. New York, NY: Modern Library. Why do firms work the way they do? For example, why do the owners of the firm hire the workers, rather than the other way around? Randall Kroszner and Louis Putterman summarize this field of economics. Randall S. Kroszner and Louis Putterman (editors). 2009. The Economic Nature of the Firm: A Reader. Cambridge: Cambridge University Press.
So in this unit we study firms. In the units to follow, we study markets. Herbert Simon, an economist, used the view from Mars to explain why it is important to study both.
The coordination of workThe way that labour is coordinated within firms is different to coordination through markets:
The prices that motivate and constrain people’s actions in a market are the result of the actions of thousands or millions of individuals, not a decision by someone in authority. The idea of private property specifically limits the things a government or anyone else can do with your possessions. In a firm, by contrast, owners or their managers direct the activities of their employees, who may number in the thousands or even millions. The managers of Walmart, the world’s largest retailer, decide on the activities of 2.2 million employees, a larger number of people than any army in world history before the nineteenth century. Walmart is an exceptionally large firm, but it is not exceptional in that it brings together a large number of people who work together in a way coordinated (by the management) to make profits. Unlike flash mobs, firms do not form spontaneously and then disappear. Like any organization, firms have a decision-making process and ways of imposing their decisions on the people in it. When we say that ‘Apple outsourced its component production’ or ‘the firm sets a price of $10.75’, we mean that the decision-making process in the firm resulted in these actions.3 Figure 6.1 shows a simplified picture of the firm’s actors and decision-making structure. Fullscreen Figure 6.1 The firm’s actors and its decision making and information structures. Fullscreen Owners decide long-term strategies The owners, through their board of directors, decide the long-term strategies of the firm concerning how, what, and where to produce. They then direct the manager(s) to implement these decisions. Fullscreen Managers assign workers Each manager assigns workers to the tasks required for these decisions to be implemented, and attempts to ensure that the assignments are carried out. Fullscreen Flows of information The green arrows represent flows of information. The upward green arrows are dashed lines because workers often know things that managers do not, and managers know things that owners do not. asymmetric informationInformation that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.The dashed upward green arrows represent a problem of asymmetric information between levels in the firm’s hierarchy (owners and managers, managers and workers). Since owners or managers do not always know what their subordinates know or do, not all of their directions or commands (grey downward arrows) are necessarily carried out. This relationship between the firm and its employees contrasts with the firm’s relationship to its customers, which we study in the next unit. The bakery firm cannot text its customers to tell them to ‘Show up at 8 a.m. and purchase two loaves of bread at the price of €1 each’. It could tempt its customers with a special offer, but unlike the employer with its employees, it cannot require them to show up. When you buy or sell something, it is generally voluntary. In buying or selling you respond to prices, not orders. The firm is different: it is defined by having a decision-making structure in which some people have power over others. Ronald Coase, the economist who founded the study of the firm as both a stage and an actor, wrote:
Coase pointed out that the firm in a capitalist economy is a miniature, privately owned, centrally planned economy. Its top–down decision-making structure resembles the centralized direction of production in entire economies that took place in many Communist countries (and in the US and the UK during the Second World War).5 Contracts and relationshipscontractA legal document or understanding that specifies a set of actions that parties to the contract must undertake.The difference between market interactions and relationships within firms is clear when we consider the differing kinds of contracts that form the basis of exchange. A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use. A rental contract on an apartment does not transfer ownership of the apartment (which would include the right to sell it); instead it gives the tenant a limited set of rights over the apartment, including the right to exclude others (including the landlord) from its use. wage labourA system in which producers are paid for the time they work for their employers.Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and to accept the authority of the employer over the use of his or her time while at work. The employer does not own the employee as a result of this contract. If the employer did, the employee would be called a slave. We might say that the employer has ‘rented’ the employee for part of the day. To summarize:
Firms differ from markets in another way: social interactions within firms sometimes extend over decades, or even a lifetime. In markets, we shop around, so our interactions are typically short-lived and not repeated. One of the reasons for this difference is that working in a firm—as either a manager or an employee—means acquiring a network of associates who are essential for the job to be done well. Some of our workmates will become our friends. Managers and employees also acquire both technical and social skills that are specific to the firm they work for. firm-specific assetSomething that a person owns or can do that has more value in the individual’s current firm than in their next best alternative.Oliver Williamson, an economist, termed these skills, networks, and friendships relationship-specific or firm-specific assets because they are valuable only while the worker remains employed in a particular firm. When the relationship ends, their value is lost to both sides. Think about how different this is to the social interactions in the market. Although you may know the face or even the name of a person from whom you buy, or to whom you sell something, the relationship is typically temporary, in which case this knowledge has little value. This social aspect becomes important economically when economic changes disrupt social interactions. Imagine how your life as a shopper changes if your local grocery store closes tomorrow. You would have to find a new place to shop, and it might take you a few minutes to learn where the various items you need are on display. Now imagine what would change if the company in which you work goes out of business tomorrow. You would lose your network of work associates, your workplace friendships, and your firm-specific social and technical skills would suddenly have become useless to you. You might have to move to a new town. Your children would need to change school, so they would lose contact with their friends too. Thus, the people making up the firm—owners, managers, and employees—are united in their common interest in the firm’s success, because all of them would suffer if it were to fail. However, they have conflicting interests about how to distribute the profits from the firm’s success amongst themselves (wages, managerial salaries, and owners’ profits), and may disagree about other policies such as conditions of work, managerial perks, and who makes the key decisions—such as whether Apple should assemble iPhones in China or the US.
Question 6.1 Choose the correct answer(s)Which of the following statements is true?
6.2 Other people’s money: The separation of ownership and controlThe firm’s profits legally belong to the people who own the firm’s assets, which include its capital goods. The owners direct the other members of the firm to take actions that contribute to the firm’s profits. This in turn will increase the value of the firm’s assets, and improve the wealth of the owners. residual claimantThe person who receives the income left over from a firm or other project after the payment of all contractual costs (for example the cost of hiring workers and paying taxes).The owners take whatever remains after revenues (the proceeds from sale of the products) are used to pay employees, managers, suppliers, creditors, and taxes. Profit is the residual. It is what’s left of the revenues after these payments. The owners claim it, which is why they are called residual claimants. Managers (unless they are also owners) are not residual claimants. Neither are employees. This division of revenue has an important implication. If the firm’s revenues increase because managers or employees do their job well, the owners will benefit, but the managers and employees will not (unless they receive a promotion, bonus, or salary increase). This is one reason we consider the firm as a stage, one on which not all the actors have the same interests. In small enterprises, the owners are typically also the managers and so are in charge of operational and strategic decisions. As an example, consider a restaurant owned by a sole proprietor, who decides on the menu, hours of operation, marketing strategies, choice of suppliers, and the size and compensation of the workforce. In most cases the owner will try to maximize the profits of the enterprise by providing the kinds of food and ambience that people want, at competitive prices. Unlike Apple, the owner cannot outsource dishwashing or table service to a low-wage location. shareA part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm’s profit and to benefit when the firm’s assets become more valuable. Also known as: common stock.In large corporations, there are typically many owners. Most of them play no part in the firm’s management. The owners of the firm are the individuals and institutions, such as pension funds, that own the shares issued by the firm. By issuing shares to the general public, a company can raise capital to finance its growth, leaving strategic and operational decisions to a relatively small group of specialized managers. These decisions include what, where, and how to manufacture the firm’s products, or how much to pay employees and managers. The senior management of a firm is also responsible for deciding how much of the firm’s profits are distributed to shareholders in the form of dividends, and how much is retained to finance growth. Of course, the owners benefit from the firm’s growth because they own part of the value of the firm, which increases as the firm grows. separation of ownership and controlThe attribute of some firms by which managers are a separate group from the owners.When managers decide on the use of other people’s funds, this is referred to as the separation of ownership and control. The separation of ownership and control results in a potential conflict of interest. The decisions of managers affect profits, and profits decide the incomes of the owners. But it is not always in the interest of managers to maximize profits. They may choose to take actions that benefit themselves, at the expense of the owners. Perhaps they will spend as much as possible on their company credit card, or seek to increase their own power and prestige through empire-building, even if that is not in the interests of shareholders. Even single owners of firms are not required to maximize their profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But unlike managers, when they lose profits as a result, the cost comes directly out of their pocket. In the eighteenth century, Adam Smith observed the tendency of senior managers to serve their own interests, rather than those of shareholders. He said this about the managers of what were then called joint-stock companies: free rideBenefiting from the contributions of others to some cooperative project without contributing oneself. Smith had not seen the modern firm, but he understood the problems raised by the separation of ownership and control. There are two ways that owners can incentivize managers to serve their interests. They can structure contracts so that managerial compensation depends on the performance of the company’s share price. Also, the firm’s board of directors, which represents the firm’s shareholders and typically has a substantial share in the firm (like a representative of a pension fund), can monitor the managers’ performance. The board has the authority to dismiss managers, and shareholders in turn have the right to replace members of the board. The owners of large companies with many shareholders rarely exercise this authority, partly because shareholders are a large and diverse group that cannot easily get together to decide something. Occasionally, however, this free-rider problem is overcome and a shareholder with a large stake in a company may lead a shareholder revolt to change or influence senior management. When we model the firm as an actor, we often assume that it maximizes profits. This is a simplification, but a reasonable one for most purposes:
Question 6.2 Choose the correct answer(s)Which of the following statements about the separation of ownership and control is true?
6.3 Other people’s labourThe firm does not only manage, as Adam Smith put it, ‘other people’s money’. The decision-makers in a firm decide on the use of other people’s labour too: the effort of their employees. People participate in firms because they can do better if they are part of the firm than if they are not. As in all voluntary economic interactions, there are mutual gains. But just as conflicts arise between owners and managers, there will generally be differences between owners and managers on the one hand, and employees on the other, about how the firm will use the strength, creativity, and other skills of its employees. A firm’s profits (before the payment of taxes) depend on three things:
Our focus here is how firms seek to minimize the cost of acquiring the necessary labour to produce the goods and services they sell. We have already seen in Unit 2 how firms might increase output without raising costs by adopting new technologies, and in Unit 7 we will study their sales decisions. Hiring employees is different from buying other goods and services. When we buy a shirt or pay someone to mow a lawn, it is clear what we get for our cash. If we don’t get it, we don’t pay, but if we have already paid, we can go to court and get our money back. But a firm cannot write an enforceable employment contract that specifies the exact tasks employees have to perform in order to get paid. This is for three reasons:
To understand the last point, consider a restaurant owner, who would like her staff to serve customers in a pleasant manner. Imagine how difficult it would be for a court to decide whether the owner can withhold wages from a waiter because he had not smiled often enough. incomplete contractA contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).An employment contract omits things that both the employees and the business owner care about: how hard and well the employee will work, and for how long the worker will stay. As a result of this contractual incompleteness, paying the lowest possible wage is almost never the firm’s strategy to minimize the cost of acquiring the labour effort it needs.
piece-rate workA type of employment in which the worker is paid a fixed amount for each unit of the product made. Why is it not possible for firms just to pay employees according to how productive they are? For example, paying employees at a clothing factory $2 for each garment they finish. This method of payment, known as piece rate, provides the employee with an incentive to exert effort, because employees take home more pay if they make more garments. In the late nineteenth century the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. At the turn of the twenty-first century less than 5% of manufacturing workers in the US were paid piece rates and, beyond the manufacturing sector, piece rates are used even less often.8 Why do most of today’s firms not use this simple method to induce high effort from their employees?
If piece rates are not practical, then what other method could a firm use to induce high effort from workers? How could the firm provide an incentive to do the job well, even though the worker is paid for time and not output? Just as the owners of the firm protect their interests by linking management pay to the firm’s share price, the manager uses incentives so that employees will work effectively. Question 6.3 Choose the correct answer(s)Which of the following are reasons why employment contracts are incomplete?
Inequality 6.4 Employment rentsThere are many reasons why people put in a good day’s work. For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. Even for those not intrinsically motivated to work hard, feelings of responsibility for other employees or for one’s employer may provide strong work motivation. For some employees, hard work is a way to reciprocate a feeling of gratitude to the employer for providing a job with good working conditions. In other cases, firms identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group that is divided among team members. But in the background, there is another reason to do a good job: the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security. Laws and practices concerning the termination of employment for cause (that is, because of inadequate or low quality work, not due to insufficient demand for the firm’s product) differ among countries. In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly. But even in these cases, an employee has to fear the consequences of not working up to the employer’s desired standards. Such a worker, for example, would be unlikely to achieve a position in the firm where she could count on remaining employed when lower demand for the firm’s products results in other workers being dismissed. Do workers care whether they lose their jobs? employment rentThe economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.If firms paid their employees the lowest wages they would be willing to accept, the answer would be no. Such a wage would make the worker indifferent between remaining in the job and losing it. But in practice most workers care very much. There is a difference between the value of the job (taking into account all the benefits and costs it entails) and the value of the next best option—which is being unemployed and having to search for a new job. In other words, there is an employment rent. Employment rents can benefit owners and managers in two ways:
We can use the same reasoning in the employment of managers by the owners of the firm. The main reason owners wield power over managers is that they can fire them, and so eliminate their managerial employment rents.
Counting the cost of job lossRecall that an economic rent measures the value of a situation—for example, having your current job—compared to what you would get if the current situation were no longer possible. To calculate employment rent—or in other words, the net cost of job loss—we need to weigh up all the benefits and costs of working compared with being unemployed and searching for another job. There are some costs of working, such as:
But there are many benefits, which would be lost if you lost your job:
Even confining attention to the loss in wages, the cost is high. But how do we measure how high it is?
Question 6.4 Choose the correct answer(s)In which of the following employment situations would the employment rent be high, ceteris paribus?
Politics and policy 6.5 Determinants of the employment rentTo construct a model of how employment rents may be used to motivate employees to work hard, 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 two aspects of her job:
Using the concept of utility introduced in Unit 3, 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. Her disutility of work depends on how much effort she puts into her job. Suppose she spends half of her working time actually working, and half doing other things like checking Facebook. We represent this as an effort level of 0.5. Working this hard is equivalent to a cost of $2 per hour to Maria. To calculate her employment rent we first find her net utility of working and earning $12, compared with being unemployed and earning nothing: This is her employment rent per hour. The total employment rent (or cost of job loss), depends on how long she expects to remain unemployed. We will suppose that if she loses her job she can expect to remain unemployed for 44 weeks before finding another. The analysis in Figure 6.2 shows how to calculate the rent. Fullscreen Figure 6.2 Maria’s employment rent for a given effort and $12 wage in an economy without an unemployment benefit. Fullscreen Maria’s wage Maria’s hourly wage, after taxes and other deductions, is $12. Looking ahead from now (taken as time 0), she will continue to receive this wage for the foreseeable future if she keeps her job, indicated by the horizontal line at the top of the figure. Fullscreen The disutility of working Maria’s current effort level is 0.5: she pursues non-work activities for half of the time on the job. Working this hard is equivalent to a cost of $2 per hour to Maria. Fullscreen The net benefit of working The difference between her wage and disutility of effort is the economic rent per hour that she receives while employed. Fullscreen If Maria loses her job If instead Maria were to lose her job at time 0, she would no longer receive her wages. This unfortunate state would persist as long as she remains unemployed, indicated by the horizontal line at the bottom of the figure. Fullscreen The duration of unemployment The expected duration of unemployment is 44 weeks, where she would have worked 35 hours per week. That is how long she will remain without pay (and without the disutility of working). Fullscreen Maria finds a job Maria expects to find another job at the same wage after 44 weeks. Fullscreen Maria’s employment rent The shaded area is her total cost of job loss from the spell of unemployment, that is, her employment rent. Her total employment rent is the employment rent per hour times the number of hours of work she will lose if her job is terminated. It is the shaded area in the figure. unemployment benefitA government transfer received by an unemployed person. Also known as: unemployment insurancePeople who lose their jobs can typically expect help from family and friends while they are out of work. Also, in many economies, people who lose their jobs receive unemployment benefit or financial assistance from the government. In poorer economies, they may be able to earn a small amount in informal self-employment. reservation wageWhat an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.If Maria receives an unemployment benefit or income from any of these sources, it will partially offset the lost wage income. 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, which is the lowest wage that would induce her to accept a job in which she did not experience any disutility of work. In Figure 6.2 we show Maria’s situation where she is working hard at a job and incurring a disutility of effort of $2 per hour on the job. There is no unemployment benefit so her reservation wage is zero. With a wage of $12, her employment rent is $10 per hour. This is what she would lose, were she to lose her job and be unemployed. In Figure 6.3, we add an unemployment benefit of $6. Working as hard as before and experiencing $2 disutility of effort per hour, her employment rent is now the wage of $12 minus the disutility of effort ($2) minus the reservation wage ($6), i.e. a rent of $4 per hour. She would now lose $4 per hour, were she to lose her job and be unemployed. Fullscreen Figure 6.3 Maria’s employment rent for a given effort and a $12 wage in an economy with an unemployment benefit of $6 of unlimited duration. Our calculation of employment rent should take into account the reservation wage: And taking account of the duration of unemployment we see that: Unemployment benefits usually run out eventually: families and friends will not be able to help forever, and government unemployment benefits are often time-limited. 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.
Our next step is to study the social interaction between the employer (who sets the wage knowing that it affects Maria’s employment rent) and Maria herself, whose decision on how hard to work is influenced by the rent. Question 6.5 Choose the correct answer(s)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:
Politics and policy 6.6 Work and wages: The labour discipline modelWhen 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. Holding constant other ways that it might influence the employment rent, a firm can increase the cost of job loss, and therefore the effort exerted by its employees, by raising wages. We now represent this social interaction in the firm as a game played by the owners (through their managers) and the employees. Remember that a game is a description of a social interaction, including:
As with other models, we ignore some aspects of their interaction to focus on what is important, following the principle that sometimes we see more by looking at less. On the stage of the firm, the cast of characters is just the owner (the employer) and a single worker, Maria. The game is sequential (one of them chooses first, like the ultimatum game that we saw in Section 10 of Unit 4) and is repeated in each period of employment. Here is the order of play:
The payoff for the employer is the profit. The greater Maria’s effort, the more goods or services she will produce, and the more profit he will make. Maria’s payoff is her net valuation of the wage she receives, taking into account the effort she has expended. Nash equilibriumA set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else.If Maria’s 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. Employers typically hire work supervisors and may install surveillance equipment to keep watch on their employees, increasing the likelihood that the management will find out if a worker is not working hard and well. Here we will ignore these extra costs and just assume that the employer occasionally gets some information on how hard or well an employee is working. This is not enough to implement a piece-rate contract, but more than enough to fire a worker if the news is not good. Maria knows that the chance of the employer getting bad news decreases the harder she works. To decide on the wage to set, the employer needs to know how the employee’s work effort will respond to higher wages. So we will consider Maria’s decision first. The employee’s best responseMaria’s effort can vary between zero and one. We can think of this as the proportion of each hour that she spends working diligently (the rest of the time she is not working). An effort level of 0.5 indicates she is spending half the working day on non-work related activities such as checking Facebook, shopping online, or just staring out of the window. We will assume that Maria’s reservation wage is $6. Even if she put in no work whatsoever (and so endured no disutility of effort, spending all day on Facebook and day-dreaming) her job at a $6 wage would be no better than being without work. So she would not care one way or the other if her job ended. Her best response to a wage of $6 would be zero effort. What if she were paid a higher wage? For Maria, effort has a cost—the disutility of work—and a benefit: it increases the likelihood of her keeping the job, and the employment rent. In her choice of effort she needs to find a balance between these two. A higher wage increases the employment rent and hence the benefit from effort, so it will lead her to choose a higher level of effort. Maria’s best response (the effort she chooses) will increase with the level of the wage chosen by the employer. worker’s best response function (to wage)The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.Figure 6.4 shows the effort Maria chooses for each level of the wage, referred to as her best response curve, or best response function. (Just like the production functions in Unit 3, it shows how one variable, in this case effort, depends on another, the wage.) Fullscreen Figure 6.4 Maria’s best response to the wage. Point J refers to the information in Figure 6.3 (wage = $12, effort = 0.5 and expected duration of unemployment if she were to lose her job = 44 weeks). Fullscreen Effort per hour Effort per hour, measured on the vertical axis, varies between zero and one. Fullscreen The relationship between effort and the wage If Maria is paid $6 she does not care if she loses her job because $6 is her reservation wage. This is why she provides no effort at a $6 wage. If she is paid more, she provides more effort. Fullscreen The worker’s best response The upward-sloping curve shows how much effort she puts in for each value of the hourly wage on the horizontal axis. Fullscreen The effect of a wage increase when effort is low When the wage is low, the best response curve is steep: a small wage increase raises effort by a substantial amount. Fullscreen Diminishing marginal returns At higher levels of wages, however, increases in wages have a smaller effect on effort. Fullscreen The employer’s feasible set The best response curve is the frontier of the employer’s feasible set of combinations of wages and effort that it gets from its employees. Fullscreen The employer’s MRT The slope of the best response curve is the employer’s marginal rate of transformation of higher wages into more worker effort. Point J in Figure 6.4 represents the situation in Figure 6.3 discussed at the end of the previous section. Maria’s reservation wage is $6, she is paid $12, and chooses effort of 0.5. The best response curve is concave. It becomes flatter as the wage and the effort level increase. This is because, as the level of effort approaches the maximum possible level, the disutility of effort becomes greater. In this case it takes a larger employment rent (and hence a higher wage) to get effort from the employee. Seen from the standpoint of the owner or the employer, the best response curve shows how paying higher wages can elicit higher effort, but with diminishing marginal returns. In other words, the higher the initial wage, the smaller the increase in effort and output the employer gets from an extra $1 per hour in wages. The best response curve is the frontier of the feasible set of combinations of wages and effort the firm can get from its employees, and the slope of the frontier is the marginal rate of transformation of wages into effort. The lowest wage the firm could set for Maria would be the reservation wage, $6, where the best response curve hits the horizontal axis and effort is zero. So we can see that the firm would never offer the lowest wage possible, because she would not work. Leibniz: The worker’s best response function We have drawn the best response function in Figure 6.4 under the assumption that unemployment is expected to last 44 weeks. If the expected duration were to change, the best response function would change too. If economic conditions worsened, increasing unemployment duration, Maria’s employment rent would be higher. So for any wage, her best response would be to exert a higher level of effort. Question 6.6 Choose the correct answer(s)Figure 6.4 depicted Maria’s best response curve when the expected duration of unemployment was 44 weeks. Which of the following statements is correct?
Inequality 6.7 Wages, effort, and profits in the labour discipline modelMaria is not in the situation that Angela faced when Bruno could order her to work at the point of a gun. Maria has bargaining power because she can always walk away—an option that, initially, Angela did not have. Maria chooses how hard she works. The best the owner can do is to determine the conditions under which she makes that choice. The owners and managers know that they cannot get Maria to provide more effort than is given by the best response curve shown in Figure 6.4. 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. As we saw in Unit 2, to maximize profits, firms want to minimize the costs of production. In particular, they want to pay the lowest possible price for inputs. A company purchasing oil for use in the production process will look for the supplier that can provide it at the lowest price per litre, or equivalently, supply the most oil per dollar. Likewise, Maria provides an input to production, and her employer would like to purchase it at the lowest price. But this does not mean paying the lowest possible wage. We already know that if he paid the reservation wage, workers might show up (they wouldn’t care one way or the other), but they would not work if they did. The wage, w, is the cost to the employer of an hour of a worker’s time. But what matters for production is not how many hours Maria provides, but how many units of effort: effort is the input to the production process. If Maria chooses to provide 0.5 units of effort per hour, and her hourly wage is w, the cost to the employer of a unit of effort is 2w. In general, if she provides e units of effort per hour, the cost of a unit of effort is w/e. So, to maximize profits, the employer should find a feasible combination of effort and wage that minimizes the cost per unit of effort, 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. The upward-sloping straight line in Figure 6.5 joins together a set of points that have the same ratio of effort to wages, e/w. If the wage is $10 per hour and a worker provides 0.45 units of effort per hour, the employer gets 0.045 efficiency units per dollar. Equivalently, a unit of effort costs $10/0.45 = $22.2. The employer would be indifferent between this situation and one in which the wage is $20 with an effort of 0.9—the cost of effort is exactly the same at all points on the line. We will call this an isocost line for effort. Similarly to the isocost lines in Unit 2, these lines join points that have identical effects on the employer’s costs. We can also think of it as an indifference curve for the employer. Fullscreen Figure 6.5 The employer’s indifference curves: Isocost curves for effort. Fullscreen An isocost line for effort If w = $10 and e = 0.45, e/w = 0.045. At every point on this line the ratio of effort to wages is the same. The cost of a unit of effort is w/e = $22.22.
Fullscreen The slope of the isocost line The line slopes upward because a higher effort level must be accompanied by a higher wage for the e/w ratio to remain unchanged. The slope is equal to e/w = 0.045, the number of units of effort per dollar. Fullscreen Other isocost lines On an isocost line, the slope is e/w, but the cost of effort is w/e. The steeper line has a lower cost of effort, and the flatter line has a higher cost of effort. Fullscreen Some lines are better for the employer than others A steeper line means lower cost of effort and hence higher profits for the employer. On the steepest isocost line he gets 0.7 units of effort for a wage of $10 (at B) so the cost of effort is $10/0.7 = $14.29 per unit. On the middle line he only gets 0.45 units of effort at this wage, so the cost of effort is $22.22, and profits are lower. Fullscreen The slope is the MRS The employer is indifferent between points on an isocost line. Like other indifference curves, the slope of the effort isocost line is the marginal rate of substitution: the rate at which the employer is willing to increase wages to get higher effort. 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. The best he can do is to set the wage at $12 on the isocost line that is tangent to Maria’s best response curve (point A). Use the analysis in Figure 6.6 to see how the employer sets the wage. Fullscreen Figure 6.6 The employer sets the wage to minimize the cost of effort. Fullscreen Minimizing the cost of effort To maximize profits, the owner wants to obtain effort at the lowest cost. He will seek to get onto the steepest isocost line possible. But because he cannot dictate the level of effort, he has to pick some point on the worker’s best response curve. Fullscreen C is not the best the employer can do Could this be a point such as C? No. It is clear that by paying more the owner will benefit from a lower wage-effort ratio. Fullscreen Point A is the best the employer can do The best he can do is the isocost line that is just touching (tangent to) the worker’s best response curve. Fullscreen MRS = MRT At this point, the marginal rate of substitution (the slope of the isocost line for effort) is equal to the marginal rate of transformation of higher wages into greater effort (the slope of the best response function). Fullscreen Point B Points on steeper isocosts, such as Point B, would have lower costs for the employer but are infeasible. Fullscreen Minimum feasible costs Therefore $12 is the hourly wage that the employer should set to minimize costs and maximize profits. In Figure 6.6, the employer will choose point A, offering a wage of $12 per hour to hire Maria, who will exert effort of 0.5. The employer cannot do better than this point: any point with lower costs, for example, point B, is infeasible. The employer minimizes costs and maximizes profit at the point where his MRS (the slope of his indifference curve or isocost line) equals the MRT (the slope of the best response curve, which is his feasible frontier). He balances the trade-off he is willing to make between wages and effort against the trade-off he is constrained to make by Maria’s response. Leibniz: Finding the profit-maximizing wage This is a constrained choice problem, similar to the one in Unit 3. There, individuals maximizing utility chose working hours where MRS = MRT: the slope of their indifference curve equalled the slope of the feasible frontier determined by the production technology. efficiency wagesThe payment an employer makes that is higher than an employee’s reservation wage, so as to motivate the employee to provide more effort on the job than he or she would otherwise choose to make. See also: labour discipline model, employment rent.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. labour discipline modelA model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.What has the labour discipline model told us?
Involuntary unemploymentWhen we think about the implications of the labour discipline model for the whole economy, it tells us something else, which may at first seem surprising:
Being unemployed involuntarily means not having a job, although you would be willing to work at the wage that other workers like you are receiving. In developing our model we assumed that Maria could expect to be unemployed for 44 weeks before receiving another wage offer at the same level. But the model implies that there must be an extended period of unemployment. To see why, try to imagine an equilibrium in the game between Maria and her employer in which he pays her a wage of $12 per hour, and if she lost her job she could immediately find another at the same wage. In that case, Maria’s employment rent would be zero. She would be indifferent between keeping the job and losing it. So her best response would be an effort level of zero. But this could not be an equilibrium: the employer would not pay $12 an hour to someone who did no work. If it were ever to happen that there were plenty of jobs available in the economy at $12 per hour, and no one was unemployed, such a situation could not last. Employers would offer higher wages to ensure that their workers had something to lose and would therefore work hard. But with higher wages, they would not be able to offer as many jobs. Workers who lost their jobs would no longer be able to find new ones easily. Jobs would be scarce and it might take weeks or months to find another. The economy would have moved to an equilibrium with higher wages and involuntary unemployment. Employees would be earning $16 an hour and those who lost their jobs would be willing to accept another at $16, but they would not immediately be able to find one. In equilibrium, both wages and involuntary unemployment have to be high enough to ensure that there is enough employment rent for workers to put in effort. Unemployment is an important concern for voters and the policymakers who represent them. We can use this model to see how policies that governments pursue to alter the level of unemployment, or to provide income to unemployed workers, will affect the profits of firms and the effort level of their employees.
Question 6.7 Choose the correct answer(s)Figure 6.6 depicts the efficiency wage equilibrium of a worker and a firm. According to this figure:
Politics and policy 6.8 Putting the model to work: Owners, employees, and the economyUntil now we have considered how the employer chooses a point on the best response function. But changes in economic conditions or public policies can shift the entire best response function, moving it to the right (or up) or to the left (or down). The employee’s incentive to choose a high level of effort depends on how much she has to lose (the employment rent), but also the likelihood of losing it. So the position of the best response function depends on:
If there are changes in any of these factors, the best response curve will shift. First, imagine how an increase in the unemployment rate affects the best response curve. When unemployment is high, workers who lose their jobs can expect a longer spell of unemployment. Recall that unemployment benefits (including support from family and friends) are limited, so the longer the expected spell of unemployment, the lower the level of the unemployment benefit per hour of lost work (or per week). So an increase in the duration of a spell of unemployment has two effects:
Figure 6.7 shows the effects on the best response curve of a rise in unemployment, and also of a rise in unemployment benefits. Fullscreen Figure 6.7 The best response curve depends on the level of unemployment and the unemployment benefit. Fullscreen The status quo The position of the best response curve depends on the reservation wage. It crosses the horizontal axis at this point. Fullscreen The effect of unemployment benefits A rise in the unemployment benefit increases the reservation wage and shifts the worker’s best response curve to the right. Fullscreen An increase in unemployment If unemployment rises, the expected duration of unemployment increases. So the worker’s reservation wage falls and the best response curve shifts to the left. Fullscreen Effort changes for each wage For a given hourly wage, say $18, workers put in different levels of effort when the levels of unemployment or unemployment benefit change. A rise in the level of unemployment shifts the best response curve to the left:
A rise in unemployment benefits shifts the best response curve to the right, so it has the opposite effects. Economic policies can alter both the size of the unemployment benefit and the extent of unemployment (and hence the duration of a spell of unemployment). These policies are often controversial. A rightward shift of the employee’s best response function favours employees, who will put in less effort for any given wage, while a leftward shift favours owners, who will acquire the effort of their employees at a lower cost, raising profits.
Question 6.8 Choose the correct answer(s)Which of the following statements are true?
InequalityPolitics and policy 6.9 Another kind of business organizationcooperative firmA firm that is mostly or entirely owned by its workers, who hire and fire the managers.Even in capitalist economies, some business organizations have an entirely different structure to the one we have been analysing: their workers are the owners of the capital goods and other assets of the company, and they select managers who run the company on a day-to-day basis. This form of business organization is called a worker-owned cooperative or cooperative firm.18 19 One well-known example of a cooperative is the large British retailer John Lewis Partnership, founded in 1864 and held in trust for its employees since 1950. Every employee is a partner, and employee councils elect five out of seven members of the company board. The benefits for employees (pension, paid holidays, long-service sabbaticals, social activities) are generous, and the business’ profits are shared out as a bonus, calculated as a percentage of each person’s salary every year. The bonus normally ranges between 10% and 20% of pay, even after a significant chunk of the profits are retained for future investment. John Lewis is one of the country’s most profitable and consistently successful retail businesses. 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. Other than this, the main differences between conventional firms and worker-owned cooperatives are that the cooperatives need fewer supervisors and other management personnel to ensure that the worker-owners work hard and well. Fellow worker-owners will not tolerate a shirking worker because the shirker is reducing the profit share of the other workers. Reduced need for the supervision of workers is among the reasons that worker-owned cooperatives produce at least as much (if not more) per hour than their conventional counterparts. Inequalities in wages and salaries within the company, for example between managers and production workers, are also typically less in worker-owned cooperatives than in conventional firms. And worker-owned cooperatives tend not to lay off workers when the economy goes into recession, offering their worker-owners a kind of insurance (often they cut back on the hours of all workers rather than terminating the employment of some). Case studies show that in those unusual companies owned primarily by the workers themselves, work is done more intensely with less supervision. There have been many attempts to establish other types of business organization throughout recent history, but borrowing the funds to start and sustain worker-owned companies is often difficult because, as we will see in Unit 10, banks are often reluctant to lend funds (except at high interest rates) to people who are not wealthy.
6.10 Principals and agents: Interactions under incomplete contractsIn the relationship between Maria and her employer, Maria’s work effort matters to both parties but is not covered by the employment contract. This leads to the existence of employment rents. If they had been able to write a complete contract, the situation would have been quite different. The employer could have offered her an enforceable contract specifying both the wage and the exact level of effort she should provide, and if these terms were acceptable to her, she would have agreed and worked as required. To maximize his profit he would have chosen a contract that was only just acceptable, so she would not have earned any rents. This example is not unusual. In practice, all employment relationships are governed by incomplete contracts. Employment contracts often do not even bother to mention that the worker should work hard and well. And there are many other ways in which we interact without a complete contract:
For these and a great many other exchanges, it appears that Emile Durkheim (1858–1917), the founder of modern sociology, was right when he observed that ‘not everything in the contract is contractual.’ As above, there is usually something that matters to at least one of the parties that cannot be written down in an enforceable contract. Why are contracts incomplete?Thinking about some examples of economic interactions, we can see that there are several reasons for the absence of a complete contract:
Principal–agent modelsprincipal–agent relationshipThis relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal–agent problem.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. In the case of Maria and her employer, the employer is the principal. He would like to offer Maria, the agent, an employment contract, and she wants the job, but the amount of effort she will provide cannot be specified in the contract because it is not verifiable. This is a problem because there is a conflict of interest: he would prefer her to work hard, whereas Maria prefers an easy life. Our model of Maria’s employment is an example of a general class of principal–agent models, in which an action taken by the agent is ‘hidden’ from the principal, or ‘unobservable’.
In short: a hidden action problem occurs when there is a conflict of interest between the principal and the agent over some action that may 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 doesn’t) or unverifiable (it cannot be used by a court to enforce a contract). The table in Figure 6.8 identifies the principals and agents in the examples from this section.
Figure 6.8 Hidden action problems.
We study the banker-borrower principal–agent model in Unit 10. In Unit 12 we will introduce the second main class of principal–agent models, in which it is not the agent’s action that cannot be contracted (hidden action) but rather something about the agent herself that is unknown to the principal (hidden attribute).
6.11 ConclusionThe products of people’s labour may be transferred to others in markets, or within firms through employment contracts. To understand the role of the firm, we view it not only as an actor, but also a stage on which three sets of actors (owners, managers, and employees) interact. 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. Employment contracts are incomplete: they can cover hours and some working conditions, but not the effort provided by the employee, which is not verifiable. So employers set wages that are higher than workers’ reservation wages. Workers receive an employment rent, which motivates them to work hard and deters them from quitting. When all employers set wages in this way, there will be involuntary unemployment in the economy. Public policies such as the provision of unemployment benefits change workers’ reservation wages and best response curves, and so affect the wage-setting process.
6.12 ReferencesConsult CORE’s Fact checker for a detailed list of sources.
Which of the following correctly describes when a firm in a competitive market should shut down in the short run?Which of the following correctly describes when a firm in a competitive market should shut down in the short run? A firm will shut down in the short run when price is less than average variable cost. Following this rule will limit losses to fixed costs.
Under what conditions will a firm shut down temporarily explain quizlet?Under what conditions will a firm shut down temporarily? A firm will shut down temporarily if the revenue it would get from producing is lower than the variable costs of production. This occurs if price is less than average variable cost.
Which of the following represents the firm's short run condition for shutting down?Which of the following represents the firm's short-run condition for shutting down? marginal cost curve above its average variable cost curve.
When the firm is at its shutdown price quizlet?Answer: D The firm's shutdown point is when price equals the minimum average variable cost. 4.
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