WEEK 5

cooperative firm / worker-owned cooperative

A firm that is mostly or entirely owned by its workers, who hire and fire the managers.

unemployment benefit

A government transfer received by an unemployed person. Also known as: unemployment insurance

contract

A legal document or understanding that specifies a set of actions that parties to the contract must undertake.

utility

A numerical indicator of the value that one places on an outcome, such that higher valued outcomes will be chosen over lower valued ones when both are feasible.

employment rent

The 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.

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.

reservation wage

What 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.

Coase had also defined the firm by its political structure:

'If a workman moves from department Y to department X, he does not go because of a change in prices but because he is ordered to do so.' He sought to understand why firms exist at all, quoting his contemporary D. H. Robertson's description of them as 'islands of conscious power in this ocean of unconscious cooperation'.

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? a) If the expected unemployment duration increased to 50 weeks, Maria's best response to a wage of $12 would be an effort level above 0.5. b) If the unemployment benefit was reduced, then Maria's reservation wage would be higher than $6. c) Over the range of wages shown in the figure, Maria would never exert the maximum possible effort per hour. d) Increasing effort from 0.5 to 0.6 requires a bigger wage increase than increasing effort from 0.8 to 0.9.

- If the expected unemployment duration increased to 50 weeks, Maria's best response to a wage of $12 would be an effort level above 0.5. - Over the range of wages shown in the figure, Maria would never exert the maximum possible effort per hour. 0.5 is Maria's best response to a wage of $12 when expected unemployment duration is 44 weeks. If duration increases to 50 weeks, the cost of job loss is higher, so Maria will work harder for the same wage. The maximum level of effort would not be provided over the wage range shown.

QUESTION 6.8 CHOOSE THE CORRECT ANSWER(S) Which of the following statements are true? a) If unemployment benefits are increased, the minimum cost of a unit of effort for the employer will rise. b) If the wage doesn't change, employees will work harder in periods of high unemployment. c) If workers continue to receive benefits however long they remained unemployed, an increase in the level of unemployment will have no effect on the best response curve. d) If an employee's disutility of effort increases, the reservation wage will rise.

- If unemployment benefits are increased, the minimum cost of a unit of effort for the employer will rise. - If the wage doesn't change, employees will work harder in periods of high unemployment. An increase in unemployment benefits shifts the best response curve to the right. The employer will no longer be able to reach the isocost line tangent to the original best response curve, so the cost of effort must rise. In periods of high unemployment, the cost of job loss is higher. At any given wage level, employees will choose higher effort to reduce the chance of losing their jobs.

QUESTION 6.4 CHOOSE THE CORRECT ANSWER(S) In which of the following employment situations would the employment rent be high, ceteris paribus? a) In a job that provides many benefits, such as housing and medical insurance. b) In an economic boom, when the ratio of job-seekers to vacancies is low. c) When the worker is paid a high salary because she is a qualified accountant and there is a shortage of accountancy skills. d) When the worker is paid a high salary because the firm's customers know and trust her.

- In a job that provides many benefits, such as housing and medical insurance. - When the worker is paid a high salary because the firm's customers know and trust her. If the employee loses the job, all these benefits would be lost, so the economic rent from employment is high. This worker is paid a high salary because of firm-specific assets that will be lost if she leaves. Other firms would pay a lower salary (at least initially) so the economic rent is high.

6.10 Principals and agents: Interactions under incomplete contracts

- In 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.

6.7 Wages, effort, and profits in the labour discipline model

- Maria chooses how hard she works. - The best the owner can do is to determine the conditions under which she makes that choice. - 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.

One reason we consider the firm as a stage:

- Not all the actors have the same interests. 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).

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.

QUESTION 6.3 CHOOSE THE CORRECT ANSWER(S) Which of the following are reasons why employment contracts are incomplete? a) The firm cannot contract an employee not to leave. b) The firm cannot specify every eventuality in a contract. c) The firm is unable to observe exactly how an employee is fulfilling the contract. d) The contract is unfinished.

- The firm cannot contract an employee not to leave. - The firm cannot specify every eventuality in a contract. - The firm is unable to observe exactly how an employee is fulfilling the contract. It may be costly for the firm if the employee leaves, but employees retain the right to do so. Since the firm does not know all the tasks it will require of an employee, the contract is necessarily incomplete. Since effort or the quality of an individual's work cannot be perfectly monitored and measured, it cannot be specified in the contract.

Karl Marx (1818-1883)

- watched capitalism mature in the industrial towns of England, was to become its most famous critic. -first economist to understand why the capitalist economy was the most dynamic in human history. - In the labour market, in which owners of capital are buyers and workers are the sellers, the appearance of freedom and equality was, to Marx, an illusion. -He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities.

When we model the firm as an actor, we often assume that it maximizes profits.

1) Owners have a strong interest in profit maximization: It is the basis of their wealth. 2) Market competition penalizes or eliminates firms that do not make substantial profits for their owners: We saw this process in Unit 1 and Unit 2 as part of the explanation of the permanent technological revolution, and it applies to all aspects of the firms' decisions.

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'.

1) The agent can take some action (such as working hard), 2) the principal benefits from this action, 3) but taking the action is something the agent would not choose to do, perhaps because it is costly or unpleasant (this is the conflict of interest), 4) and because information about the action is either not available to the principal or is not verifiable, 5) there is no way that the principal can use an enforceable contract to guarantee that the action is performed.

Employment rents can benefit owners and managers in two ways:

1) The employee is more likely to stay with the firm: If she were to quit the job, the firm would need to pay to recruit and train someone else. 2) They can threaten to fire the worker: Owners and managers exert power over employees because the employee has something to lose. The threat can be implicit or explicit, but it will make the worker perform in ways that she would not choose unless this was the case.

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:

1) When the firm writes a contract for the employment of a worker, it cannot know exactly what it will need the employee to do, because this will be determined by unforeseen future events. 2) It would be impractical or too costly for the firm to observe exactly how much effort each employee makes in doing the job. 3) Even if the firm somehow acquired this information, it could not be the basis of an enforceable contract.

A firm's profits (before the payment of taxes) depend on three (3) things:

1) costs of acquiring the inputs necessary for the production process 2) output (how much these inputs produce) 3) sales revenues received from selling goods or services

incomplete contract

A 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).

FIRM

1) owners or their managers direct the activities of their employees, who may number in the thousands or even millions. (Example: Walmart) 2) firms have a decision-making process and ways of imposing their decisions on the people in it. **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.

MARKET

1) 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. 2) The idea of private property specifically limits the things a government or anyone else can do with your possessions.

The position of the best response function depends on:

1) the utility of the things that can be bought with the wage 2) the disutility of effort 3) the reservation wage 4) the probability of getting fired when working at each effort level * If there are changes in any of these factors, the best response curve will shift.

John Stuart Mill (1806-1873)

1. English Utilitarian and essayist best known for writing "On Liberty" and "The Subjection of Women" 2. Advocated women's rights and endorsed universal suffrage

Communist Manifesto (1848)

A book written by Karl Marx. It suggested that there would be a social revolution in which the proletariat (working class) would overthrow the bourgeoisie (middle class factory owners) and then set up a classless, socialist community. This book was the blueprint for communist governments around the world.

firm

A business organization which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit. * Firms are major actors in the economy * 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. **the majority of people in rich nations make their living by working in a firm.

share

A 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. * 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.

wage labour

A system in which producers are paid for the time they work for their employers. 1) Contracts for products sold in markets permanently transfer ownership of the good from the seller to the buyer. 2) Contracts for labour temporarily transfer authority over a person's activities from the employee to the manager or owner.

piece-rate work

A type of employment in which the worker is paid a fixed amount for each unit of the product made. Why do most of today's firms not use this simple method to induce high effort from their employees? 1) It is very difficult to measure the amount of output an employee is producing in modern knowledge- and service-based economies (think about an office worker, or someone providing home care for an elderly person). 2) Employees rarely work alone, so measuring the contribution of individual workers is difficult (think about a team in a marketing company working on an advertising campaign, or the kitchen staff at a restaurant).

natural experiment

An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

Diminishing marginal returns

At higher levels of wages, however, increases in wages have a smaller effect on effort.

free ride

Benefiting from the contributions of others to some cooperative project without contributing oneself. - a shareholder with a large stake in a company may lead a shareholder revolt to change or influence senior management.

Ronald Coase, the economist who founded the study of the firm as both a stage and an actor

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

Coase and Marx on the firm and its employees

Coase thought that the hierarchy of the firm was a cost-reducing way to do business. Marx thought that the coercive authority of the boss over the worker limited the employee's freedom.

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.

labour discipline model told us?

Equilibrium: In the owner-employee game, the employer offers a wage and Maria provides a level of effort in response. Their strategies are a Nash equilibrium. Rent: In this allocation Maria provides effort because she receives an employment rent that she might lose if she were to slack off on the job. Power: Because Maria fears losing this economic rent, the employer is able to exercise power over her, getting her to act in ways that she would not do without this threat of job loss. This contributes to the profits of the employer.

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.

Figure 6.4 shows the effort Maria chooses for each level of the wage, referred to as her best response curve/worker's best response function (to wage)

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).

Labour Coordination

Firms represent a concentration of economic power: This is placed in the hands of the owners and managers, who regularly issue directives with the expectation that their employees will carry them out. An 'order' in the firm is a command. Markets are characterized by a decentralization of power: Purchases and sales result from the buyers' and sellers' autonomous decision. An 'order' in a market is a request for a purchase that can be rejected if the seller pleases.

A rise in the level of unemployment shifts the best response curve to the left:

For a given wage, say $18, the amount of effort that the worker will provide increases, improving the profit-making conditions for the employer. The wage that the employer would have to pay to get a given effort level, say 0.6, decreases. 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.

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.

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: 1) The employer chooses a wage: This is based on his knowledge of how employees like Maria respond to higher or lower wages, and informs her that she will be employed in subsequent periods at the same wage—as long as she works hard enough. 2) Maria chooses a level of work effort: This is in response to the wage offered, taking into account the costs of losing her job if she does not provide enough effort. 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. 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.

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

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. 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.

QUESTION 6.1 CHOOSE THE CORRECT ANSWER(S) Which of the following statements is true? a) A labour contract transfers ownership of the employee from the employee to the employer. b) The office where the employee works is a relation-specific asset, because the employee cannot use it after leaving the firm. c) In a labour contract, one side of the contract has the power to issue orders to the other side, but this power is absent from a sale contract. d) A firm is a structure that involves decentralization of power to the employees.

In a labour contract, one side of the contract has the power to issue orders to the other side, but this power is absent from a sale contract. ** A labour contract gives the employer the authority to direct the activities of the employee, whereas a sale contract transfers property rights and does not bind the parties to further actions.

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. ** 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.

asymmetric information

Information 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 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.

Hiring labour is different from buying other goods and services, and the contract between the employer and the employee is incomplete.

It does not cover what the employer really cares about, which is how hard and well the employee works.

The employee's best response

Maria'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. 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.

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: a) The employment rent per hour is $3. b) Maria's reservation wage is $6 per hour. c) Maria's employment rent if she can get another job with the same wage rate after 44 weeks of being unemployed is $6,160. d) Maria's employment rent if she can only get a job at a lower wage rate after 44 weeks of being unemployed is more than $7,700.

Maria's employment rent if she can only get a job at a lower wage rate after 44 weeks of being unemployed is more than $7,700. CORRECT: If she could get a job at the same wage after 44 weeks, Maria's employment rent = $5 (employment rent per hour) × 35 hours per week × 44 weeks = $7,700. If the new job would have a lower wage, her employment rent would be higher than $7,700.

QUESTION 6.2 CHOOSE THE CORRECT ANSWER(S) Which of the following statements about the separation of ownership and control is true? a) When the ownership and control of a firm is separated, the managers become the residual claimants. b) Managers always work to maximize the firm's profit. c) One way to address the problem associated with the separation of ownership and control is to pay the managers a salary that depends on the performance of the firm's share price. d) It is effective for shareholders to monitor the performance of the management, in a firm owned by a large number of shareholders.

One way to address the problem associated with the separation of ownership and control is to pay the managers a salary that depends on the performance of the firm's share price. Such performance-related pay is a common method of incentivizing managers to maximize the value of their firm.

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.

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: employment rent per hour=wage−reservation wage−disutility of effort=wage−unemployment benefit−disutility of effort=$12−$6−$2=$4 And taking account of the duration of unemployment we see that: total employment rent=employment rent per hour × expected hours of lost work time=$4 per hour × 1,540 hours=$6,160 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.

Figure 6.1 shows a simplified picture of the firm's actors and decision-making structure.

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. 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. 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.

Figure 6.6 The employer sets the wage to minimize the cost of effort.

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. 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.

firm-specific asset or relationship-specific

Something that a person owns or can do that has more value in the individual's current firm than in their next best alternative.

separation of ownership and control

The attribute of some firms by which managers are a separate group from the owners. * The separation of ownership and control results in a potential conflict of interest. * Adam Smith observed the tendency of senior managers to serve their own interests, rather than those of shareholders.

best response function/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.

efficiency wages

The 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.

residual claimant

The 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 following are NOT residual claimants: **Managers (unless they are also owners) ** Neither are employees.

Offshoring and outsourcing

The 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.

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: a) Along the isocost line tangent to the best response curve, doubling of the per-hour effort from 0.45 to 0.90 would lead to an increased profit for the firm. b) The slope of each isocost line is the number of units of effort per dollar. c) At the equilibrium point, the marginal rate of transformation on the isocost line equals the marginal rate of substitution on the worker's best response curve. d) Points C and A both represent Nash equilibria because they are on the best response curve.

The slope of each isocost line is the number of units of effort per dollar. ** Isocost lines have a constant ratio of effort to wage, e/w. Since e is on the vertical axis, and w is on the horizontal axis, the slope is e/w, which is the number of units of effort per dollar.

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.

division of labour

The specialization of producers to carry out different tasks in the production process.

unemployment, involuntary

The state of being out of work, but preferring to have a job at the wages and working conditions that otherwise identical employed workers have. See also: unemployment.

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

Why are contracts incomplete?

There are several reasons for the absence of a complete contract: 1) Information is not verifiable: For a contract to be enforceable, relevant information must be observable by both parties, but also verifiable by third parties such as courts of law. The court must be able to establish whether or not the requirements of the contract were met. Verifiable information is often unavailable: for example, it may be impossible to prove whether the poor condition of a rented apartment is due to normal wear and tear or the tenant's negligence. 2) Time and uncertainty: A contract is generally executed over a period of time, for example specifying that Party A does X now and Party B does Y later. But what B should do later may depend on things that are unknown when the contract is written. People are unlikely to be able to anticipate every possible thing that might happen in future—and trying to do so would probably not be cost-effective. 3) Measurement: Many services and goods are inherently difficult to measure or describe precisely enough to be written into a contract. How would the restaurant owner measure how pleasantly his waiters interact with customers? 4) Absence of a judiciary: For some transactions there are no judicial institutions (courts or other relevant third parties) capable of enforcing contracts. Many international transactions are of this type. 5) Preferences: Even where the nature of the goods or services to be exchanged would permit a more complete contract, a less complete contract might be preferred. Intrusive surveillance of workers by employers may backfire if the employer's distrust angers the workers, leading to less satisfactory work performance. You do not necessarily want to know the exact quality of a concert before you buy the ticket—discovering it may be part of the experience.

Firms do not pay the lowest wages possible.

They set wages so that employees earn economic rents, to motivate them to work effectively, and stay with the firm.

hidden actions (problem of)

This occurs when some action taken by one party to an exchange is not known or cannot be verified by the other. For example, the employer cannot know (or cannot verify) how hard the worker she has employed is actually working. Also known as: moral hazard. See also: hidden attributes (problem of). 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).

principal-agent relationship

This 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.

6.5 Determinants of the employment rent

To determine her economic rent, we need to think how she would evaluate two aspects of her job: 1) The pay that she gets: which is something she values. 2) How hard she works: she would like to do no more work than is necessary.

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: 1) It reduces the reservation wage: This increases the employment rent per hour. 2) It extends the period of lost work time: This increases total employment rents (the cost of job loss). Figure 6.7 shows the effects on the best response curve of a rise in unemployment, and also of a rise in unemployment benefits.

developing countries

additional business costs such as health and safety rules are far lower, and environmental regulations are often less strict.

principal-agent model

can be used to study other relationships with incomplete contracts, such as the interaction between a lender and a borrower.

6.8 Putting the model to work: Owners, employees, and the economy

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)

6.9 Another kind of business organization

cooperative firm

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.

costs of working, such as: 1) The disutility of work: Employees must spend time doing things they would prefer not to do. 2) The cost of travelling to work every day. benefits, which would be lost if you lost your job: 1) Wage income: This may be partially offset by an unemployment benefit or, in poorer countries, by the possibility of lower-paying self-employment or work on the family farm. 2) Firm-specific assets: These include workplace friends, and perhaps the proximity of the workplace to your present home. 3) Medical insurance: The employer may pay for the employee's healthcare in some countries. 4) The social status of being employed: In Unit 13 we will see that the stigma of being unemployed is equivalent to a substantial financial cost for most people.

6.3 Other people's labour

decision-makers in a firm decide on the use of other people's labour too: the effort of their employees.

In economics:

employment is modeled as a principal (the employer) interacting with an agent (the employee).

division of labour is coordinated in two major ways:

firms and markets - Through firms, the components of goods are produced by different people in different departments of the firm, and assembled to produce the finished shirt or iPhone. - Or components produced by groups of workers in different firms may be brought together through market interactions between firms. - By buying and selling goods on markets, the finished iPhone gets from the producer into the pocket of the consumer, and the American Apparel shirt ends up on somebody's back.

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.

Incomplete contracts arise when:

important information, such as the employee's effort, is asymmetric or non-verifiable

To calculate her employment rent we first find her net utility of working and earning $12, compared with being unemployed and earning nothing:

net utility per hour=wage − disutility of effort per hour=$10 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. 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. total employment rent= employment rent per hour×expected lost hours of work=$10 per hour×1,540 hours=$15,400

reserve army of the unemployed

pool of available job-seekers contribute to low wages & instability

Working together in firms brings mutual gains:

profit for owners, and economic rents for managers and employees. But rents also lead to involuntary unemployment in the economy.

Herbert 'Herb' Simon (1916-2001)

used the view from Mars to explain why it is important to study both firms and markets.