Lecture
The firm, as one of the basic institutions of the modern economic system, is above all a separate subject of economic activity, carrying out its functions in the external economic environment, which includes consumers, suppliers, the state, competitors, natural conditions, and society as a whole. The firm differs from other economic agents in that it:
When examining economic processes, we constantly analyze the activity of the enterprise or firm as their principal subject. The existence of firms has a certain theoretical justification. As is well known, there are two basic forms of organizing economic activity: spontaneous order (a term coined by F. Hayek) and hierarchy. Spontaneous order presupposes the coordination of actions through the market, when the decision is made by the party to the transaction independently, on the basis of its own motives and the information available. As a rule, information about prices exerts a significant influence on the decision in this case.
Hierarchy presupposes the subordination of the individual actions of separate participants to the orders of a central authority. The role of coordinator in a hierarchical system is performed by the manager. His orders are unconditionally accepted by subordinates and are binding. Under this form of economic organization, priority is given not to price but to the dictate of the manager, who consciously plans and organizes everything.
The internal structure of a firm represents a typical example of hierarchy. A firm operates as an integral, coordinated system, within which the principle of subordination of the firm's employees to the orders of the manager applies.
A firm is a set of relations among employees, managers, and owners. These relations are often expressed through formal agreements - contracts. But even where the relations are not regulated by a formal agreement, there exist rules of behavior between the firm's employees, between employees and managers, and between suppliers and consumers of the product. These rules of behavior can be regarded as informal contracts, since they are fairly stable over long periods of time, and their violation triggers formal or informal sanctions from other participants.
The firm, being a set of internal and external contracts, faces two types of expenditures in order to ensure that they are carried out. A special role among these is played by «transaction costs». To carry out its production activity, a firm bears production costs. However, in addition to the costs directly connected with production, the firm also incurs non-production costs. These arise in the course of economic activity and include the costs of preparing, concluding, and carrying out transactions. These costs have come to be called transaction costs (from the Latin transactio - agreement). Indeed, in order to carry out a transaction, a firm needs to:
1) select potential partners and gather information about them (the informational component of the costs);
2) convince them of the profitability of carrying out the transaction (this includes the whole complex of marketing and advertising efforts);
3) conduct negotiations and draw up an agreement (the costs of concluding the transaction itself);
4) secure guarantees that the agreement will be carried out (the costs of monitoring performance of the transaction).
The firm and the market represent alternative methods of economic organization. Production can be organized in a decentralized way, by means of purely market relations, but a hierarchical principle of organization within a single firm can also be used.
It is evident that, under market conditions, the choice of a particular method of economic organization is determined by the magnitude of the transaction costs corresponding to each of them. Firms (the hierarchical path) survive in those cases where the transaction costs within the firm turn out to be lower than the comparable market costs.
In practice, in different spheres of economic life one or the other method of economic organization predominates. Thus, no firm carries out an audit of its own accounting books itself. Conversely, secret commercial projects are never entrusted to outsiders, their execution being assigned to trusted employees of one's own. On the whole, the fact that firms dominate the market economy testifies to a significant reduction in transaction costs through the use of hierarchical methods of organization within the enterprise.
The factors ensuring the high efficiency of the firm consist in the following. A firm is better adapted to carrying out complex business operations and coordinating specialized resources. The specific nature of a firm's work is connected with the need to carry out a multitude of transactions. In this case, the resources involved are usually needed for a long period and are specialized in character.
By accumulating a large quantity of resources for a long period, a firm has the opportunity to replace a number of separate transactions for attracting factors with a single long-term contract. This leads to a significant reduction in the amount of transaction costs. If similar transactions were carried out through the market, additional costs would arise from setting prices for each factor, along with the costs of conducting negotiations and concluding a separate contract for each market transaction.
The presence of hierarchy within the firm makes it possible to control the allocation and use of resources, which also leads to a reduction in costs. A simple order can be used to redeploy additional workers to a difficult section of work. In the same way, material and financial resources can be redistributed within the company. If every such operation had to involve external suppliers (a purely market, non-hierarchical solution), such maneuvers would be impossible.
The firm reduces the risk of bad faith that counterparties to a transaction might display in the following forms: outright deception; concealment of the true reasons for concluding the agreement; use of information available to only one of the parties to the agreement; and so on.
In order to avoid or significantly reduce the danger of deception, the firm introduces precautionary measures, creating a system for monitoring the fulfillment of obligations. The forms of monitoring can be quite varied: strong motivation of managers to achieve the success of the firm, certification of employees, audits, the conduct of scheduled and surprise inspections, stocktaking, and so on.
A firm adapts more easily to sudden changes in the situation. The firm's increased adaptability to unexpected circumstances that arise is again connected with the hierarchy existing within it. Another important point is that the firm, as an organization capable of foresight, can forecast the development of events and build up reserves in advance to minimize the consequences.
Thus, although a firm cannot completely rid itself of transaction costs, carrying out business operations within it entails lower costs compared with similar expenditures under market organization. The firm acts as a means of economizing on transaction costs.
In addition to transaction costs, a firm also bears control costs. If transaction costs are the costs (explicit and implicit) of ensuring the performance of external contracts, then control costs are the costs associated with internal contracts. Control costs include the expenses of monitoring the performance of internal contracts, as well as losses resulting from the improper performance of contracts.
From this point of view, the market and the firm represent alternative methods of concluding contracts. The market can be interpreted as a network of external contracts, and the firm as a network of internal contracts. A firm can buy a product or service on the market by concluding a corresponding agreement with another, external, counterparty, but a firm can also produce the good itself, using internal contracts with employees. The choice between external and internal contracts depends on the ratio of the costs of using them. The higher the transaction costs compared with the control costs, the higher the probability that the good will be produced by the firm rather than by the market.
Transaction costs are especially high compared with control costs in situations where there exist opportunities and incentives for opportunistic behavior:
The growth of transaction costs due to the inefficiency of external contracts limits the scope of the market's activity. This, in turn, accounts for the existence of relatively large firms, for which the problem of external agreement and the possibility of opportunistic behavior is in many cases removed through the development of internal contracts.
The question now arises: why does the market exist at all, if the firm provides savings on transaction costs? Why are external contracts needed at all?
As a firm grows, the number of employees and the fragmentation of the production process increase (a characteristic example being an assembly line with separate operations), so that the aggregate result of the firm's activity turns out to be the work not of one or a few employees, as in the pre-industrial era, but of many divisions and a multitude of employees. As a result, the direct link between labor and its outcome, characteristic of small-scale production, is lost. And immediately the «free-rider» problem appears: a reduction in the work intensity of one employee has no direct effect on the firm's aggregate output and may go unnoticed, and this therefore tempts employees not to work at full effort. Self-monitoring of work intensity ceases to serve as a means of increasing production efficiency, and a supervisory authority is forced to take its place. Control costs for monitoring the degree of work intensity (activity) of each production unit appear and grow. The larger the firm becomes, the higher these control costs turn out to be. Eventually, the costs of ensuring the performance of internal contracts exceed the transaction costs, the attractiveness of market contracts compared with internal ones increases, and internal contracts are replaced by external ones.
The firm, as a separate subject of economic activity, exists between two types of costs - transaction costs, which determine the lower boundary of the firm, its minimum size, and control costs, which set the upper boundary, its maximum size.
The contractual approach to the firm allows us to distinguish two fundamental organizational forms of the firm: the U-form and the M-form.
The U-form (from the English unitary) is distinguished by small control costs and large transaction costs. This is a simple linear firm, characterized by the sequential subordination of the stages of output to a single regulating center.
The control functions are arranged «in a line», which gives a saving on control costs: at any given moment, one division controls and is controlled by only one other division. However, since only the last division (as a rule, the sales department) deals directly with the consumer, while the other departments have no direct contact with the market, such a form can exist only for homogeneous, small-scale production; as the number of product lines or the volume of output grows, the absence of a link with the market makes it difficult for production to respond to changes in demand, which makes this form less flexible and, consequently, less competitive in the long run. For this reason, this form is characteristic only of small and medium-sized firms. The small size of such firms, in turn, leads to high costs of performing external contracts. Thus, the U-form gives rise to relatively small control costs at the expense of high transaction costs.
The M-form (from the English multiproduct) represents the parallel subordination of all the stages of output of each product to a single product center.
Here, dealing with consumption and the market for all products is handled by central management rather than by individual product or production divisions, which makes it possible to respond promptly to changes in the market parameters of demand for any product being manufactured. This contributes to the flexibility of production, which leads to the organization of a multi-product process on a large scale. Transaction costs decrease, since many intermediate products are manufactured within the firm. However, the increased complexity of the system for managing product divisions leads to an increase in control costs.
But if a firm, with its hierarchical principle of organization, is more efficient than market organization, then why does the market exist alongside firms? Why can the whole economy not be organized as a single gigantic firm or a single country-factory?
Economic theory answers this question as follows. As the size of the firm increases, the costs of organizing additional transactions within the firm rise. Consequently, the firm cannot expand indefinitely, but only up to the size at which the costs of organizing one additional transaction within the firm become equal to the costs of carrying out a similar transaction through exchange on the open market, or become equal to the costs of organizing it through another firm.
Let us trace exactly how the growth of transaction costs is expressed as the size of the firm changes. As the scale of the firm increases, so does the number of transactions it carries out. Sooner or later their number exceeds the physical capacity of a single person. From this point on, the entrepreneur engaged in coordinating resources proves unable to allocate and use the factors of production optimally, and begins to make errors in management. This phenomenon in economics has come to be called the loss-of-control phenomenon. The way out lies in creating a managerial pyramid that distributes the decision-making process among many people. But here another danger lurks. A growing firm gives rise to an «information distortion effect» as information is repeatedly transmitted between people.
Since a manager can work directly with only a small number of employees subordinate to him, an increase in the size of the firm is accompanied by growth in the number of levels of hierarchy. The transmission of information through these levels is delayed, and the information becomes distorted. The firm becomes bureaucratized, that is, the flexibility of the decisions taken is lost and errors appear.
Another problem that arises as the size of the firm increases lies in the weakening of motivation. In a giant corporation, managers at various levels are merely hired employees, often performing their work without the enthusiasm and initiative of the owner of a small firm who strives for success. The market is capable of creating and sustaining more powerful incentives. A large firm must therefore bear additional costs for organizing control over the proper use of the factors of production. Finally, the growth of transaction costs also occurs because of the need to keep additional records and draw up reports.
This raises new questions: to what size can a firm expand? Where exactly does the boundary of the firm's efficiency lie? What serves as the criterion of its optimality?
The criterion of optimality for a firm is the amount of transaction costs. As soon as the transaction costs of managing within the firm begin to exceed the costs of market transactions outside it, the size of the firm should be limited, since it becomes inefficient.
The development of many large firms strictly followed this rule. The rapid growth of a firm and the increase in its size ultimately led to excessive hierarchy and bureaucratization of organizational structures. There was a significant increase in the costs of transmitting the information needed for business decisions; the decision-making process became protracted. The firm lost its former flexibility, and its economic indicators deteriorated rapidly. As a result, either the firm perished, or it had to reduce its size: sell off part of its plants, and lay off workers and managers.
A partial way out of this situation was found by combining the hierarchical principle of organization with spontaneous order within the firm. Firms began to single out independent organizational units within their overall structure. These «profit centers», as they came to be called, were assigned general tasks for remitting profit to the company's headquarters, and in exchange were granted broad rights of self-management. Such a management system makes «profit centers» very similar to independent firms of smaller size, and through such «downsizing» it reduces intra-firm transaction costs. At present, the introduction of «profit centers» is one of the main and progressive directions in the transformation of large enterprises in our country.
Nevertheless, «profit centers» do not fully remove the problem of the inefficiency of excessive giantism. The possibilities for decentralizing a firm's structure have limits, beyond which it turns into a conglomerate of unmanageable divisions. This kind of experience, incidentally, is also already familiar to domestic enterprises. Many of our giants were in fact destroyed from within by small enterprises created within their own framework that pursued self-interested policies.
Since the role of firms in the economy consists in producing goods and services, the technological approach to the firm is one of the central ones in the theory of markets. According to this approach, the firm is viewed as a structure that optimizes costs for a given output, which is determined by the technological features of production. Minimum costs per unit of output are achieved at the output level known as the minimum efficient scale (MES) for a given industry. The dependence of costs on output determines the technological boundary of the firm, and the horizontal and vertical boundaries of the firm's growth. The horizontal boundary is understood in two senses: as the volume of output of a single product (the limits of growth of a single-product firm) and as the range of products within a single firm (the limits of production diversification).
All firms can be divided into single-product and multi-product ones (by the number of goods produced within a single firm), on the one hand, and into single-plant and multi-plant ones (by the number of establishments with a relatively self-contained production cycle - plants), on the other.
The horizontal size of a firm is determined by the positive effect of scale, that is, by the subadditivity of costs: costs are subadditive if they are lower for the joint output of several goods than for their separate production within different firms.
If the production of a single good is being considered, this refers to a simple positive economy of scale - a reduction in the average costs of producing a good as the quantity of it increases; if the production of several goods is being considered, this refers to a positive economy of scope - a reduction in the average costs of producing one type of good as the number of product brands produced within a single firm increases.
The concept of cost subadditivity within the technological approach to the firm makes it possible to answer the question of why the economy as a whole, and even often a single industry, cannot be represented by a single firm. The growth of costs per unit of output as the scale of production increases forms the technological boundary of the firm. Overcoming the tendency of average costs to rise within one and the same firm is possible by singling out within the firm several relatively independent divisions that would act as quasi-firms, that is, by changing the internal organization of the firm.
The subadditivity of costs also determines the vertical size of the firm: the firm's choice between buying on the market or producing within the firm products of successive processing stages. Goods will be produced within the firm (the firm will become vertically integrated) if the costs of their combined production are lower than the costs of purchasing them
Accordingly, a decrease in the subadditivity of costs tends to halt the vertical expansion of the firm and limits its vertical growth. Thus, the technological approach to analyzing the firm makes it possible to identify the production constraints on the firm's expansion in breadth and in depth, to establish the natural limits of its size, and to determine the technical conditions for the efficiency of its operation.
Until now the firm has been considered as an object acted upon by the external environment, as a passive structure of the economy. The firm was credited only with the ability to react to the surrounding economic environment, for example, to the technology or contractual relations prevailing in the industry. However, the firm not only submits to economic relations but also shapes them itself. The view of the firm as an active subject of the market forms the basis of the strategic approach to the firm.
The purpose of the firm's activity is realized through its strategy. Strategy is understood in a broad sense, that is, as the conscious, purposeful behavior of the firm both in the short run and in the long run. In forming its strategy, the firm takes into account the behavior of other economic agents, primarily the behavior of its competitors, as well as demand and the actions of the government. The firm actively influences demand by shaping consumer preferences. The firm influences the government, seeking the desired regulation of taxation, customs duties and quotas, the allocation of subsidies, the adoption of antitrust laws and exemptions from them. The firm becomes an active participant in shaping industry, microeconomic, and often macroeconomic government policy. In this case, the parameters of the firm's behavior - the price, quality and quantity of the goods produced, the purchase of resources, the hiring of personnel, the issuance of securities, financial relations with suppliers and customers - act as factors of the firm's strategic behavior, by means of which it achieves its goals.
Production costs represent payment for the factors of production acquired. Production costs – are the expenses, the monetary outlays that must be incurred for the efficient operation of an enterprise. economic, or imputed, costs are the expenses of a firm incurred under conditions of adopting the best economic decision on the use of resources. The costs that a firm or industry incurs in producing a given volume of output depend on the possibility of changing the quantity of all resources employed. The quantity of many resources used can be changed easily and quickly. Other resources require more time to acquire, for example the capacity of a manufacturing enterprise, the number of units of production equipment, etc. thus, an enterprise's costs depend on the period of time over which the enterprise adapts to changed conditions. A distinction is made between the short run and the long run. Their difference is already known.
Fixed costs (TFC)– are those that an enterprise must bear in any case and which, to a certain degree, depend little on the volume of production. This refers to the building, lighting, payment of the managerial and administrative apparatus, etc. If shown graphically, the line of fixed costs looks as follows.
Variable costs(TVC) – those that are associated with expenditures on the purchase of raw materials and labor, and whose application directly affects the volume of output produced (the more output, the greater the volume of raw materials used).
At first variable costs grow in proportion to the change in the volume of production, then savings in variable costs are achieved under mass production and the rate of their growth decreases. The third period is characterized by growth in variable costs due to the disruption of the optimal size of the enterprise. This is possible with an increase in transportation costs due to increased volumes of raw materials brought in, volumes of finished products that must be sent to the warehouse, etc.
In order to more precisely determine the possible volumes of production at which a firm safeguards itself against excessive growth in production costs, the dynamics of average costs are examined. A distinction is made between average fixed costs (AFC), average variable costs (AVC), and average total costs (ATC). These costs are obtained by dividing by the corresponding quantity of output.
The next type of cost is opportunity cost. These are the costs of forgone opportunities, that is, a comparison of the current costs and benefits in a given industry with alternative profits and losses.
Marginal, or additional, costs represent the expenditure on each additional unit of output. They can be defined as the ratio of the change in total costs (TC) to the change in quantity (Q). Marginal costs can also be defined as the ratio of the change in variable costs to the change in the quantity of output. This is possible because fixed costs remain unchanged, and the change in total costs represents the change in variable costs.
In the long run, all desired changes can be carried out, both within a single firm and by other firms in the industry. The industry as a whole can change its scale. Note that in the long run there exist only average total costs, without division into fixed and variable, since in the long run all costs are variable. In the long run, owing to the possibility of changing the size of capacities, what is known as returns to scale of production appears.
The main factors influencing an increase in returns to scale are the following:
A fundamentally important factor causing a decrease in returns to scale is the manageability of the production function. As a firm grows, the problem of integrating the various aspects of its diverse activity arises. The decision-making process becomes more complex, and the administrative burden grows. A decrease in returns to scale begins when managers lose contact with day-to-day operations and recognize the need to delegate authority to lower-level managers, which leads to a gradual decline in efficiency.
The main motive and driving force behind a firm's activity is the pursuit of profit. Profit is usually defined as the difference between total revenue and total costs and is described by the expression p=TR-TC, where p is profit. However, there are two distinct concepts for calculating profit – accounting profit and economic profit. Accounting profit – is the difference between total revenue and explicit costs. Explicit costs – are the payments made by the firm to resource suppliers, creditors, etc.
Economic profit – is the difference between total revenue and all costs, both implicit and explicit. Implicit costs – are the costs of resources owned and used by the firm itself. For example, these include payments on shares. Another element of implicit costs is normal profit. This is the minimum profit necessary for the firm to remain in business. Thus, economic profit is any income in excess of normal profit.
The economic system of private enterprise has given rise to numerous and conflicting discussions about profit – its basis, functions, and qualities. For convenience, the various theories of profit, and the economic role of these theories, are grouped into three broad categories:
Let us briefly consider each of them. According to the first concept, it is argued that normal profit is the payment to the entrepreneur for his services in coordinating and controlling the firm's diverse activities, as well as for risk. This concept also takes into account the role of shareholders, who take on part of the firm's risk. Therefore, profit can be viewed as fair compensation and a reward to investors for their willingness to risk their venture capital and finance a business whose prospects are unclear.
According to the next concept, profit may be the result of luck, chance, competitive advantages, market disequilibrium, and (or) insufficiently vigorous competition. This allows firms to earn monopoly profit.
A common feature of the third group of profit theories is that above-average profitability is explained by the influence of technology and innovation. Thus, at the basis of earning profit in this concept lie technologically advanced methods of production and innovation.
However, in practice there is usually not a single cause of earning profit. The profit obtained by a firm is almost always the result of a combination of causes and factors. Profit arises from the action of factors internal or external to the firm, or, in other words, profit arises from the difference in the positions occupied by firms in the markets and the competitive superiority of one firm over another. Since the market and competitive advantages of a firm are diverse, no single theory can adequately explain above-average profit. Therefore, only their interconnection makes it possible to explain the emergence of profit.
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