I. Two means of organizing economic activity in a capitalistic society

A. Firm - an organization that transforms inputs (resources) into outputs (values products that it sells). Usually assume that firms seek to maximize profits.

B. Markets - purchase products from firms that make them.

II. How does a firm decide to buy something or make it itself?

A. Examples - Car Manufacturer; Computer Manufacturer (flow chart)



B. Make it itself due to high transaction costs (cost of negotiating contract and ongoing enforcement - can't include all contingencies) and opportunistic behavior (taking advantage of another when allowed by circumstances).



1. Asset specificity - a product that is specialized or custom-made. Ex. GM Auto bodies



2. Changing market conditions - people have bounded rationality (a limited ability to enumerate and understand all future possibilities).



3. Information as a product - consultant - hard to judge product.



C. Buy from market due to employees working less than if they were self-employed and coordination of activities that grow exponentially.



1. Incentives can help workers work harder - piece rate; bonuses and stock ownership.



2. Cost of coordination and supervision must be weighed against transactions costs.

III. Organization within firms

A. Traditional Hierarchy (chain of control)



B. Functional Separation vs. Multidivision form (M-form)

IV. Forms of ownership

A. Sole proprietorship - single owner



B. Partnership - multiple owners



C. Corporations - stockholders/shareholders own the company with limited liability - liability limited to the amount invested in company - equity owners. Corporations also borrow money - some through bonds - debt holders. Highly leveraged (high debt to equity ratio) firms are more risky for equity owners.

V. Reasons for Mergers and Acquisitions

A. Reasons that Increase Efficiency



1. Increase in Optimal Scale



2. Synergies/Economies of Scope



3. Improved management



B. Reasons that Do Not Increase Efficiency



1. Taxes - losses of one firm offset profits of another



2. Exploitation - slash workers for short term gain



3. Market or political power

VI. Alchian/Demsetz article

A. Metering Problem - measuring input productivity and apportioning rewards.



B. Team Production - several resources are used and output is not separable.





C. Shirking - not working as hard as possible.



1. Must align incentives for firm and workers goals. (Carrot)



2. Assign residual claimant to monitor workers. (Stick)

Review Questions:

1. What are two ways of organizing economic activity?



2. Explain reasons for and against large firms.



3. Do mergers always increase efficiency? When do they? When don't they?