Unit6 Feb2015 PDF

6
February 2015 beta
THE FIRM AND ITS

EMPLOYEES
Courtesy of National Archives, USA
THE ROLE OF THE FIRM IN THE ECONOMY AND THE INTERACTION

AMONG THE FIRMS EMPLOYEES, MANAGERS AND OWNERS.
You will learn:

How firms are both an actor in the economy and a stage for interactions among the firms
employees, managers and owners.
That the balance of bargaining power among employees, managers and owners affects
how the mutual gains created in the firm are distributed.
Why hiring labour is different from buying other goods and services and why the contract
between the employer and the employee is incomplete.
That firms do not pay the lowest wages possible; but instead set wages to motivate
employees to work effectively, to stay with the firm, and to make it practical for the firms
to recruit new workers when they need them.
How the wages that firms pay their employees are influenced by factors that change the
balance of bargaining power among the firms actors.
What the wage curve is; and what it can tell us about the relationship between wages
and unemployment in the economy as a whole.
See www.core-econ.org for the full interactive version of The Economy by The CORE Project.
Guide yourself through key concepts with clickable figures, test your understanding with multiple choice
questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,
watch economists explain their work in Economists in Action and much more.
Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po
coreecon | Curriculum Open-access Resources in Economics

apples 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
wages and other costs.
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 companies including Toshiba and
Sharp in Japan; the microprocessor by Samsung in South Korea; other components by
Infineon in Germany. Like other firms, Apple makes profits by finding the supplier
that can provide inputs at the least cost, whether the input is a component or labour,
and 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 4% of total costcompared to the cost of components sourced from highwage economies such as Germany and Japan. More than half of Apples 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 2009, when the
iPhone 3G cost $178 to manufacture, it was retailing in the US for $499.
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, previously done by local
employees, to poorer countries where
wages are lower. More than 97% of
apparel and 98% of footwear sold in the
US by American brands and retailers is
made overseas. Garment manufacturing
in the US is so rare that the company
American Apparel can make this feature
Apple Store, Fifth Avenue, New York.
of its clothes a distinctive selling point.
Photo by Jorge Lascar.
China, Bangladesh, Cambodia, Indonesia
and Vietnam have become the worlds
main exporters of textiles and clothing.
Not only are wages low in these economies, but additional business costs such as
public holidays or health and safety rules are far lower in developing countries, and
environmental regulations are often less strict.
The examples dramatise the fact that the economy is made up of people doing
different things; some producing the Apple display modules, others producing
American Apparel clothing. Among those producing the display modules there are
also a vast number of distinct tasks, and different employees within Toshiba or Sharp,
UNIT 6 | THE FIRM AND ITS EMPLOYEES

the companies that produce the modules for Apple, do these tasks. Different people
producing different things and carrying out different tasks in the production of a
given product is termed specialisation, or the division of labour. In previous units we
have not considered this essential aspect of the economy: in each of our examples
there has been a single product, such as the students exam results, the farmers
grain, or the garment made from the thread spun by the jenny.
When people engage in different tasks in producing different goods there must be
some way that the results of their efforts get from the hands of the producers to those
who use them. This was not a complex problem when most families produced most
of what they needed, relying little on other producers. But in a modern and global
economy, different products like shirts or flash drives, and different components of
products like the collars on the shirts or microprocessors in computers, have to end
up not where they were produced but where they are needed. There has to be a way to
coordinate the division of labour.
Setting aside the work done in families, such as cooking and caring for children and
the elderly, there are two major ways that the division of labour are coordinated:
markets and firms. By buying and selling of goods on markets, the finished iPhone
gets from the producer into the pocket of the consumer, and the American Apparel
shirt ends up on somebodys back. Apple, Samsung, American Apparel and Toshiba
are business organisations called firms. Through firms the components of the
goods produced by different people in different departments of the firm, or even in
different firms (as in the case of Apple) are brought together to assemble the finished
shirt or iPhone. In this unit we study firms. In the four units that follow, we will study
markets.
6.1 THE FIRM: AN ACTOR AND A STAGE
apple, samsung, american apparel and toshiba are business

organisations called firms. Firms employ people and purchase the inputs they need
to produce and market goods at prices that more than cover the cost of production.
Not everyone is employed in a firm. Some work independently, but are neither
employee nor employer: for example many farmers, carpenters, software developers
or personal trainers. Others work for governments and not-for-profit organisations;
but the majority of people in rich nations make their living by working in a firm.
Firms are major actors in the economy and in the next two units we explain how
firms work. Firms are often referred to as if they were people: we talk about the price
Apple charges, and American Apparels choice of an advertising strategy. But while

firms are actors, firms are also the stage on which the people who make up the firm
employees, managers, and ownersact out their sometimes common, sometimes
competing, interests.
In this unit we discuss the firm as a stage on which these actors cooperate and
conflict with each other. As was the case with Bart and Angela in the previous
unit, we will see that the people making up the firm can realise mutual gains from
exchange in the sense that they are all better off in their firm than they would be
either on their own, or in some other firm. They will also have conflicting interests
about how these gains will be shared. In the next unit we look at the firm as an actor
in its relationship with other firms and with its customers.
6.2 FIRMS AND FLASH MOBS
firms are not flash mobs. Like any organisation, firms have a decision-making
process and ways of imposing their decisions on the people in the firm. Figure 1 is a
simplified picture of the firms actors and decision-making structure.
INSIDE THE FIRM
Board of Directors (Owners)
Manager
Workers
Figure 1. The firms actors and decision-making structures.

The arrows in the figure represent directions or commands. The owners, through
their board of directors, direct the manager (or managers) to implement decisions
about the long-term strategies of the firm concerning how, what, and where to
produce. The manager in turn assigns workers to the tasks required for these
decisions to be implemented, and attempts to ensure that the assignments will be
carried out. 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. In Figure 1, decision-making in the firm flows from the top
of the chart downward.
Why does so much of a modern economy consist of top-down organisations? When
the demand for, say, a car like a Chevrolet Volt or a Mahindra Xylo increases, why
shouldnt independent workers spontaneously come together, negotiate their
payments, and start working like a flash mob? Why will the additional cars to meet
the demand be produced in existing organisations under the direction of managers?
Evidently, products made by spontaneously associating workers are more expensive
than ones made by companies that have longer-term employees organised
hierarchically. Presumably, operating as an organisation with clear lines of authority
saves on negotiating time and other costs of contracting. Constant change is normal
in capitalist economies, so the ability to reassign workers flexibly is valuable. If
workers are roughly indifferent between one task and another it pays a company
to offer a steady wage, perhaps at a premium over the earnings of a self-employed
individual, in exchange for the right to tell workers what to do and to change these
instructions as external conditions change.
This relationship between the firm and its employees contrasts with the firms
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 8am 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, and motivated by your own
wants or those of your family or others who you care about. 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 20th century economist who
founded the study of the firm as both a stage and an actor, wrote:
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 the distinguishing mark of the
firm is the suppression of the price mechanism.
The people making up the firmowners, managers, and employeesare united in
their common interest in the success of the firm because all of them would suffer if
it were to fail. Their interests will clash about the distribution of wages, managerial
salaries and owners profits in a successful firm, as well as other policies such as
conditions of work, managerial perks, and the critical issue of who makes key
decisionssuch as whether Apple should assemble iPhones in China or the US.
6.3 BIG IS BEAUTIFUL (OR AT LEAST PROFITABLE)
e. f. schumachers Small is Beautiful, published in 1973, advocated small-scale

production by individuals and groups in an economic system designed to emphasise
happiness rather than profits. In the year the book was published, the firms Intel
and FedEx each employed only a few thousand people in the US; 40 years later, Intel
employs around 108,000 and FedEx more than 300,000 people. In 1973 Walmart
employed 4,500 people; in 2014 it employs 2.2 million.
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0
2010
2000
1990
1980
1970
1960
1950
1940
1930
1920
WALMART
MCDONALD'S
FORD
FEDEX
PROCTOR & GAMBLE
INTEL
DELL
AMAZON
1910
1900
Number of employees (millions)
Most firms in the US are much smaller, but in all of the rich economies most people
work for large firms. In the US, half of private sector employees work in firms with at
least 1,000 employees. The main reason is that owners of firms make more money if
they can expand to a larger size, and people with money to invest get higher returns
from owning stock in large firms. Employees in large firms are also paid more. Figure
2 shows the growth of some highly successful US firms.
Figure 2. Firm size in the United States: number of employees (1900-2006).

Source: Luttmer, E. 2011. On the mechanics of firm growth. Review of Economic Studies, 78, pp. 1042-1068.
DISCUSS 1: FALL OF FORD

Compare the path of Ford to that of the other firms in Figure 2. What might explain
the difference in the trends?
An important reason that a large firm may be more profitable than a small firm is
that the large firm can produce its output at lower cost per unit. The reduction in the
cost per unit of output as a firm produces more units may result from the fact that
large-scale production uses fewer inputs per unit of output, termed economies of scale.
Economies of scale may occur for engineering reasons: transporting more of a liquid
requires a larger pipe, but doubling the capacity of the pipe increases the diameter of
the pipe (and the material necessary to construct it) by much less than a factor of two,
as our EINSTEIN shows.
Economies of scale may also result from specialisation among members of the firm,
allowing employees to do the task at which they are best. Cost per unit will also fall,
as the firm produces more products, if there is a fixed cost that is required for the
firm to produce even a single unit, which then does not increase for additional units.
An example would be the cost of research and product design, acquiring a licence
to engage in production, or obtaining a patent for a particular technique. Marketing
expenses such as advertising are another fixed cost. A 30-second advertisement
during the television coverage of the US Super Bowl football game in 2014 cost $4m, a
cost that would be justifiable only if the product would sell a large number of units as
a result.
The cost of a firms attempt to gain favourable treatment by government bodies
through lobbying, contributions to election campaigns and public relations
expenditures are also a kind of fixed cost. These expenses are incurred more or less
independently of the level of the firms output. We return to the question of fixed
costs in the next unit.
Large firms are also able to purchase their inputs on more favourable terms than
smaller firms. Sam Walton, the founder of Walmart, had a motto: always low prices.
This is partly possible because of the bargaining power that Walmart has when it
purchases from smaller suppliers.
An important source of economies of scale occurs when people are more likely to buy
a product or service if it has a lot of users already. Examples are telephones, which
are more useful the more people you can call, or software, which is more useful when
everybody is using compatible versions. These demand-side scale economies are
called network effects, and there are many examples in technology-related markets.
EINSTEIN: THE SIZE AND COST OF A PIPE

The size and cost of a pipe. We can use simple mathematics to work out how much
the cost increases when the size of the pipe doubles. The formula for the area of a
circle is:
Area of circle = x (radius of circle)2
Let us assume the area of the pipe was originally 10cm2, and then it was doubled in
size to 20cm 2. We can use the equation above to find the radius of the pipe in each
case:
When the area of the pipe is 10, the radius is equal to the square root of (10/) =
1.78cm.
When the area of the pipe is 20, the radius is equal to the square root of (20/) =
2.52cm.
We can now work out the circumference of the pipe, which tells us the cost of pipe in
each case. The formula for the circumference of a circle is:
Circumference of circle = 2 x x radius of circle
When the area of the pipe is 10, the circumference is equal to 2 x x 1.78 = 11.18cm.
When the area of the pipe is 20, the circumference is equal to 2 x x 2.52 = 15.83cm.
The pipe has doubled in capacity, but the circumference, and hence the cost of the
pipe, has only increased by a factor of 15.83/11.18 = 1.42. We can clearly see that the
firm has benefitted from economies of scale.
Economies of scale, and other reasons why producing on a large scale reduces costs,
are a powerful influence on firm size, and often make production by a small group of
people too costly for them to compete with larger firms.
On the other hand, economies of scale are likely to stretch only so far. Eventually,
an organisation could become so large that some costs might increase with scale.
For example, in large organisations it might become costly to coordinate across
the different parts of the production process, to manage effectively, and to respond
quickly and effectively to change. Economies might give way to diseconomies of scale.

The possibility of diseconomies of scale is reflected in the make-it-or-buy-it decision
by firms: sometimes it is cheaper to purchase part of the product rather than
manufacture it. Apple would be gigantic had it decided that Apple employees would
produce the touch screens, chipsets and other components that make up the iPhone
and iPad rather than purchasing these parts from Toshiba, Samsung and other
suppliers. Apples outsourcing strategy limits the firms size, and increases the size of
Toshiba, Samsung and other firms that produce Apples components.
TEST YOUR UNDERSTANDING

Test yourself using multiple choice questions in the full interactive version at
www.core-econ.org.
6.4 OTHER PEOPLES MONEY: THE SEPARATION OF OWNERSHIP AND CONTROL
the firms profits legally belong to the owners of the business. They own
whatever remains after revenues (the proceeds from sale of the products) are used
to pay employees and managers, suppliers, creditors and taxes. Profit is the residual:
that is, whats 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 workers. A job done well by a manager or a worker,
which causes the firms revenues to increase, will benefit the owners; but unless it
results in a promotion, a bonus or a salary increase, it will not benefit the actor. This
is one reason why when we consider the firm as a stage. Not all the actors have the
same interests.
In small enterprises, the owners are typically also the managers, 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 maximise the profits of the enterprise by providing the kinds of
food and ambiance the people want at competitive prices. Unlike Apple, the owner
cannot outsource dishwashing or table service to a low-wage location.
In large corporations, there are typically many owners. Most of them play no part
in 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
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general public a company can raise capital to finance its growth, leaving strategic
and operational decisions to a relatively small group of specialised managers.
These decisions include what, where and how to manufacture, or how much to pay
employees and managers. The senior management of a firm is also responsible for
deciding how much of the firms 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 firms growth because what they own is part of the value of the firm, which
increases as the firm grows. When managers decide on the use of other peoples
funds, this is referred to as the separation of ownership and control.
The decisions of managers affect profits, and hence the incomes of the owners. But,
given the separation of ownership and control, managers need not simply seek to
maximise profits, as did the owner of the restaurant. The separation of ownership
and control results in a potential conflict of interest: managers may choose to
take actions that provide them with private benefits at the expense of the owners.
Examples are lavish spending on managerial perks, or a business strategy that is
better aligned with managerial interests than with the interests of shareholders.
Even single owners of firms are not required to maximise their profits. They can
choose menus or employees for their own personal reasons but, unlike managers,
when profits are lower as a result the cost comes directly out of their pocket.
In the 18th century Adam Smith observed the tendency of senior managers to serve
their own interests, rather than those of shareholders. He had this to say of the
managers of what were then called joint-stock companies:
[B]eing the managers rather of other peoples money than of their own, it cannot
well be expected, that they should watch over it with the same anxious vigilance with
which the partners in a [firm managed by its owners] frequently watch over their
own Negligence and profusion, therefore, must always prevail, more or less, in the
management of the affairs of such a company.
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 incentivise
managers to serve their interests. They structure contracts so that managerial
compensation depends on the performance of the companys share price. Also
the firms board of directors, who represent the firms shareholders and whose
membership typically include owners (like pension funds) with a substantial share in
the firm, monitor the performance of the management. The board has the authority
to dismiss managers, and shareholders have the right to replace members of the
board. The owners of large companies with many shareholders rarely exercise this
authority, in part because shareholders are a large and diverse group that cannot
easily work together to do something. Occasionally, however, a shareholder with a
large stake in a company may lead a shareholder revolt to change or influence senior
management.
6.5 OTHER PEOPLES LABOUR
the firm does not solely manage, as Smith put it, other peoples money. The
decision-makers in a firm decide on the use of other peoples labour too: the efforts
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. Firms in capitalist economies sell goods or services with the
aim of making a profit. A firms profits (before the payment of taxes) depend on three
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.
In Unit 2 we saw how a firm might increase output without raising costs by adopting
a new technology. In the next unit we study how the firm decides what price to
charge. Here we study how firms seek to minimise the cost of acquiring the necessary
labour to produce the goods and services that they sell. We will see that this is not
accomplished by paying the lowest possible wages, because the employer faces the
problems of worker motivation, worker retention and worker recruitment.
Hiring employees is different to 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 dont
get it, we dont pay. If we have already paid, we go to court and get our money back.
But a firm cannot write an enforceable employment contract specifying the exact
tasks employees have to perform.
This is true for three reasons:
1. When the firm writes the contract for the employment of a worker, it cannot know
exactly what it will need the worker to do, because this will be determined by
necessarily unforeseen future events.
2. It would be impractical or too costly for the firm to observe exactly how much
effort each employee puts in to the job.
3. Even if the firm somehow acquired this information, it could not be the basis of
an enforceable contract. To understand this, consider a restaurant owner who
would like his 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
waitress because she had not smiled often enough.
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In addition, because it costs the firm to find and train new workers, it has an interest
in employees staying in the job once they have been selected and trained. But, in
most countries, binding an employee to a job for a long time is illegal. And because
employees sometimes do leave, the firm would like to have a large pool of qualified
applicants in line as replacements.
Because employment contracts cannot protect the firm from workers who fail to
work hard or well enough, and because they cannot stop employees leaving the firm,
we say that the employment contract is incomplete. Things that both worker and firm
care about are omitted: 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 least
possible wage is almost never the firms strategy to minimise the cost of acquiring the
labour effort it needs.
DISCUSS 2: BUYING SHARES, HIRING WORKERS

What does the owner get when he or she buys shares in a firm? What does the
manager get when he or she hires workers? Compare the situations highlighting the
similarities, as well as the differences, between them.
Before we show why this is true, think about situations, both past and present, in
which an employer can force a worker to carry out orders by threatening physical
punishment, or worse. Slaves, for example, worked hard under the threat of a
whipping.
In most capitalist economies firms cannot threaten physical coercion. The
employment contract is a voluntary exchange. Even if their bargaining powers are
very different, both parties must agree.
A solution that avoided physical coercion that was widely used in the past was to pay
employees for each unit of output they produced: for example, paying employees
at a clothing factory $2 for each garment. In the late 19th century the pay of more
than half of US manufacturing workers was based on their output. This method of
payment, known as piece rate, provides the employee with an incentive to exert effort;
employees take home more pay if they make more garments.
Piece rates are not widely used in modern economies. At the turn of the 21st 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. Manufacturing
accounts for only a small proportion of employment in developed economies (9%
of non-farm employment in the US), so piece rates are an extremely rare form of
compensation across the economy.

Why do todays firms not typically use this simple method to induce high effort
from their employees? First, in modern service-based economies it is very difficult
to measure the amount of output an employee is producing (think about an office
worker, or someone providing home care for an elderly person). Second, 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).
In other cases, while a worker generates an observable quantity of output, effort
affects the quality of this output (politeness to customers or accuracy in stitching
garments), and that quality may be difficult to measure at the time. There are
also examples in which a worker can increase quantity by skimping on the care
of equipment belonging to the company. In both cases, the company may have to
avoid paying a piece rate in case it accidentally encourages poor quality or raises
maintenance costs.
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 firms share price, the
manager uses incentives so that employees will work effectively.
6.6 EMPLOYMENT RENTS AND WORK
there are many reasons why people put in a good days work. For many, doing
a good job is its own reward; doing anything else would violate the employees work
ethic. Even for those not intrinsically motivated to work hard and well, feelings of
responsibility for other employees, or for ones employer, may provide strong work
motivations. For others, hard work is just a way that the employee can reciprocate
a feeling of gratitude to the employer for providing a job with good working
conditions.
But, in the background, there is another reason to do a good job: fear of losing the
job, or of missing the opportunity to be promoted into a position that has greater
security against being laid off.
The economist Joseph Stiglitz (who won the Nobel prize for his work in how markets
function) and his co-author Carl Shapiro wrote an influential academic paper in 1984
about Unemployment as a worker discipline device. More than 100 years earlier
Karl Marx had made the same point in his famous book Capital, in which he described
unemployed labour as an industrial reserve army.
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PAST ECONOMISTS
KARL MARX
Adam Smith, writing at the birth of
capitalism in the 18th century, was
to become its most famous advocate.
Karl Marx (1818-1883), who watched
capitalism mature in the industrial towns
of England, was to become its most
famous critic.
Born in Prussia (now part of Germany),
he distinguished himself as a student
at a Jesuit high school only by his
rebelliousness. In 1842 he became a writer
and editor for the Rheinische Zeitung, a
liberal newspaper, which was then closed
by the government, after which he moved
Source: John Mayall [Public domain], via
to Paris, met Friedrich Engels, with whom
Wikimedia Commons.
he collaborated in writing The Communist
Manifesto (1848), and moved to London in
1849. At first Marx and his wife Jenny lived in poverty. He earned money by writing
about political events in Europe for the New York Daily Tribune.
Marx saw capitalism as just the latest in a succession of economic arrangements in
which people have lived since pre-history. Inequality was not unique to capitalism,
he observedslavery, feudalism, and most other economic systems had shared this
feature, but capitalism also generated perpetual change and growth in output.
He was the first economist to understand why the capitalist economy was the
most dynamic in human history. Perpetual change arose, Marx observed, because
capitalists could survive only by introducing new technologies and products, finding
ways of lowering costs, and by reinvesting their profits into businesses that would
perpetually grow.
This, he claimed, inevitably caused conflict between employers and workers. Buying
and selling goods in a market appeared to be transactions among equals: nobody
is in a position to order anyone else to buy or sell. 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.
Employers did not buy the employees work, because this cannot be purchased, as
we have seen in this unit. Instead the wage allowed the employer to rent the worker
and to command workers inside the firm. Workers were not inclined to disobey
because they might lose their job and join, in the phrase that Marx used in Capital
(1867), the reserve army of the unemployed. Marx thought that the power wielded
by employers over workers was a core defect of capitalism.
Marx also had influential views on history, politics, and sociology. He thought that
history was decisively shaped by scarcity and technological progress interacting
with economic institutions, and that political conflicts arose from conflicts about the
distribution of income and the organisation of these institutions. He thought that
capitalism, by organising production and allocation in anonymous markets, created
atomised individuals instead of integrated communities.
In recent years economists have returned to themes in Marxs work to help explain
economic crises. Among these themes: the firm as an arena of conflict and of the
exercise of power (this unit), the role of technological progress (Units 1 and 2) and
the problems created by inequality (Unit 19).
In a capitalist economy, the owners and managers of the firm determine who can
work there. Recall from the previous unit that ownership of something means the
right to exclude others from its use, so ownership of a factory or office gives the
owners the right to hire and fire. In this way the owners and managers of the firm not
only determine the wage of the employee, but can also terminate employment if they
are not satisfied that the employee is working hard or well enough. If a firm is paying
a wage higher than the lowest wage at which the worker would take a job, then the
worker has an incentive to work hard and well, so as not to lose that job. Owners and
managers set wages and working conditions so that losing a job is usually a serious
economic problem for the employee.
Because owners and managers decide whether an employee stays or goes, they can
use the implicit threat of being fired to make the worker perform in ways that that
person would not perform if the threat wasnt made. This means that the owners
and managers have power over employees: in this context power means the ability to
use the threat of imposing a serious cost on another, to induce the other to act in the
interests of the person wielding power, when the reverse is not true.
The employment rent is a measure of what we call the cost of job loss. Note that 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.
15
16

Recall that a rent measures the value of a situation compared to your reservation
optionthat is, what you would get if the current situation were no longer possible.
The employment rent or cost of job loss for a worker or a manager includes:
1. The lost income while searching for a new job (perhaps offset by an unemployment
insurance benefit).
2. The psychological costs of losing workplace friends.
3. Possibly needing to relocate with ones family to some other locality where jobs are
easier to get.
4. Depending on the country, possibly the loss of medical insurance available through
the employer.
5. It also includes the social stigma of being unemployed. As we will see in Unit 12,
for most people is equivalent to a substantial financial cost..
But even confining attention to the loss in wages, the cost is high. We cannot
compare workers with jobs with the unemployed to find out the cost of job loss,
because the unemployed are different people who, even if employed, might earn
less than those currently with jobs. On the other hand we can look at the earnings
histories of workers before and after they lost their job during a mass layoff, in
other words a retrenchment caused by a condition such as insufficient demand for a
product, rather than any particular characteristic of the worker under study.
A study of experienced full time workers hit by mass layoffs in the US state of
Pennsylvania in 1982 allows us to make this comparison. In 2014 dollars, those
displaced had been averaging about $55,000 in earnings in the year prior to their
layoff. Those who were fortunate enough to find another job less than three months
after they lost their job took much less well paying jobs, averaging only $35,000:
a loss of $20,000 in the first year after the layoff. Four years later they were still
making $12,000 less than other workers had been making the same initial wage, but
whose firms did not retrench. Many, of course, did not find work at all. They suffered
even greater costs so, even though 1982 was not a good year to be looking for work in
Pennsylvania, these losses reflect the real cost of job loss for workers. Even without
placing a value on the psychological and other costs of the experience, it is safe to say
that in the five years that followed their layoff they lost the equivalent of an entire
years earnings.
To understand what determines the size of the employment rent, think about a
particular employee, Maria, whose situation is depicted in Figure 3. We do not
compare Maria with someone who is out of work, but rather let Maria compare her
current situation at work with how things would be if she had just lost her job.
17
10
Hourly wages, $
Wage
Disutility
of effort
1.5
0
What Maria gets should she not lose her job today
Marias rent when employed
Net benefit
from working
Disutility of effort when employed
Opportunity
cost of working
0 What Maria gets

should she lose
her job today
Weeks
36
Expected duration
of unemployment
Figure 3. Marias employment rent for a given effort and $10 wage: an economy without
unemployment benefit.
INTERACT
Follow figures click-by-click in the full interactive version at www.core-econ.org.
At time 0, she receives a weekly wage after the payment of taxes and other
deductions (indicated by the horizontal blue line), which she will continue to receive
for the foreseeable future if she keeps her job. Marias wages allow her to buy goods
and services that raise her utility. But she dislikes putting in as much effort as her
employer requires at work, so a proportion of her wages is merely compensating her
for the disutility of working. Her disutility of working is also termed her opportunity
cost of working because it is what she gives up by working (she could be not working
and free of the unpleasant experience of working harder than shed like).
The difference between her wage per hour and her opportunity cost of working
(disutility of effort per hour) is the net benefit per hour on the job that she receives
from being employed.
If Maria were to lose her job at time 0, however, she would no longer receive her
wages (indicated by the horizontal red line); and this unfortunate state persists as
long as her spell of unemployment goes on. Of course, she no longer has to put in
18

work effort and this small compensation for her job loss also persists as long as she
is unemployed. The expected duration of her unemployment is simply the number of
weeks that she will remain without pay (and also without the disutility of working).
For this illustration, lets say that when she goes back to work it is at the same pay
as the job that she lost (as indicated by the jump in the red line when Marias spell of
unemployment comes to an end). We can now use Figure 3 to trace the path of Marias
hourly income in two scenarios; the red line shows what happens if she were to lose
her job at time 0, and the blue line shows what happens if she keeps her job.
Every week Maria is unemployed she experiences a loss of the wage, partially offset
by the fact that she does not have to provide effort. How much is her net loss from the
spell of unemployment? The answer is Marias employment rent, or cost of job loss.
So this is her net benefits of working (the wage minus the disutility of working) times
the period of time during which she would not have this benefit.
We can see from Figure 3 that her hourly wage is $10, which if she works for 40 hours
per week, translates into a $400 weekly wage. In addition, her disutility of effort is
$60 per week ($1.50 per hour x 40 hours = $60 per week), and suppose she expects her
unemployment to persist for 36 weeks. Marias total net loss from losing her job is
equal to:
($400 $60) (36 weeks) = $12,240
This is also referred to as her employment rent (as shown by the shaded blue area in
Figure 3).
In many economies, those who lose their job may receive some government transfers
in the form of unemployment insurance or assistance to purchase necessities. If
this is the case, we can add what is termed the unemployment benefit as a partial
compensation for job loss. This also continues for as long as the individual remains
out of work.
Figure 4 shows Juans employment rent. He lives in an economy with an
unemployment benefit that means that, if he has a job and loses it, he receives a
payment from the government (sometimes called unemployment insurance). For Juan
the opportunity cost of working is now greater than the disutility of effort that he
experiences because, if he were not working, he would also receive unemployment
benefit. He both endures hard work and foregoes the unemployment benefit.
19
Wage
Unemployment
benefit
12
Hourly wage, $
Unemployment
benefit plus the
disutility of effort
What Juan gets should he not lose his job today

What Juan gets should he lose his job today
Juans rent when employed
Net benefit
from working
5
Disutility of effort when employed
3
Opportunity
cost of working
What Juan receives in unemployment

benefit during his period of
unemployment
0
Weeks
44
Expected duration
of unemployment
Figure 4. Juans employment rent for a given effort and a $12 wage: an economy with
Suppose the unemployment benefit is equal to $3 per hour, or $3 x 40 = $120 per
week. Juans wage is higher than Marias; he earns $12 per hour, which translates
to a weekly wage of $480. In addition, Juans disutility from working is higher than
Marias at $2 x 40 = $80 per week and if he does lose his job, he can expect to be
unemployed for longer, 44 weeks instead of 36. How does Juans employment rent
compare to Marias? Juans net loss occasioned by losing his job is equal to:
($480 $120 $80) (44 weeks) = $12,320
We can see from the calculation, and from the size of the shaded blue area in Figure
4, that Juans rent is a similar size to Marias, even though we have supposed that he
is unemployed for longer. Unemployment benefit reduces the employment rent. The
social safety net introduced by Juans government dramatically reduces employment
rents in the economy by lowering the cost of job loss. Another way of expressing this
is to say that the existence of unemployment benefits increases the opportunity cost
of working.
You can see from Figure 4 that for a given wage of $12 an increase in the duration
of unemployment or a decrease in the unemployment benefit would have similar
effects: both increase Juans employment rent (increasing the blue rectangle in the
figure). But this does not make Juan better off: his rent did not get larger because his
wage went up; it increased because his situation without his current job got worse.
The increase in the employment rent makes him more worried about losing his job.
So an increase in the duration of employment or a decrease in the unemployment
benefit will motivate Juan to work harder because the cost of job loss has gone up. To
find out how to calculate an employment rent using probabilities, see LEIBNIZ 8.
20
LEIBNIZ
For mathematical derivations of key concepts, download the Leibniz boxes from
www.core-econ.org.
What would be the effect of an improvement in his working conditions (his employer
installs air conditioning, for example)? Return to Figure 4. The effect would be to
reduce the disutility of effort so, if nothing else changed, his employment rent would
go up because he would value his job more (he would still be making $12 an hour and
working at half speed, but now enjoying his time on the job a bit more due to the air
conditioning). Because the cost to him of losing this job is now higher than before, he
would be willing to work harder to avoid bearing the cost of job loss. As we will see,
this is one of the reasons why owners and managers of firms care about providing
their employees with amenities, such as air conditioning, that they prefer.
WHEN ECONOMISTS AGREE
RONALD COASE AND KARL MARX ON THE FIRM AND ITS EMPLOYEES
The writer George Bernard Shaw (1856-1950) joked that If all economists were laid
end to end, they would not reach a conclusion.
This is amusing, but not entirely true.
For example, the two leading economists of the early 19th centuryMalthus and
Ricardowere political opponents. The latter often sided with businessmen, for
example in supporting freer imports of grain to Great Britain so as to reduce food
prices and allow lower wages. Malthus opposed Ricardo and supported the Corn
Laws that restricted grain imports, a position favoured by the landed gentry. But the
two economists independently developed the same theory of land rents, which we
still use today.
Even more striking is that two economists from different centuries and political
orientations came up with similar ways of understanding the firm and its employees.
In the 19th century Marx contrasted the way buyers and sellers interact on a
market, voluntarily engaging in trade, with how the firm is organised as a topdown structure, one in which employers issue orders and workers follow them. He
called markets a very Eden of the innate rights of man, but described firms as
exploit[ing] labour-power to the greatest possible extent.
When the economist Ronald Coase (who we will study in more detail in Unit 10) died
in 2013, he was eulogised by Forbes magazine as the greatest of the many great
University of Chicago economists. The motto of Forbes is The capitalist tool, and
the University of Chicago has a reputation as the centre of conservative economic
thinking.
Yet, like Marx, Coase stressed the central role of authority in the firms contractual
relations: Note the character of the contract into which an [employee] enters that is
employed within a firm... for certain remuneration [he] agrees to obey the directions
of the entrepreneur. Coase 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.
Coase sought to understand why firms exist at all, calling them islands of conscious
power in this ocean of unconscious cooperation.
Both based their thinking on careful empirical observation, and they arrived at a
similar understanding of the hierarchy of the firm. They disagreed, however, on the
consequences of what they observed: 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 employees freedom. But, like Malthus and
Ricardo, Coase and Marx disagreed while advancing economics with a common idea.
6.7 EMPLOYMENT RENTS AND EMPLOYEE EFFORT
employment rents provide the incentive for workers to work harder than
they would choose. The managers of the firm occasionally get some information
on how hard or well a worker is working. This is not enough to implement a piece
rate contract, but more than enough to fire the worker if the news is not good. The
employee knows that the chance of the employer getting bad news decreases the
21

harder the employee works. An employee who works constantly at the physical
maximum effort level might be able to eliminate the possibility of bad news entirely,
but this would be unsustainable.
Firms typically pay for supervisors and surveillance equipment to keep watch on
their workers, 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 managers sometimes get the bad news when a worker is not performing.
When the cost of job loss is large, the prospect of becoming unemployed is more
frightening, and workers will be willing to work harder. A firm can make the cost
of job loss greater by raising wages. Figure 5 shows the relationship between effort
and wages. Effort per hour varies between zero and one. We can think of this as the
proportion of each hour that the worker spends working diligently. For example, an
effort level of 0.5 indicates the worker is spending half the day on non-work related
activities such as checking personal email, shopping online, or staring out of the
window. The upward-sloping red curve shows how much effort the worker puts in for
any hourly wage. This is referred to as the workers best response function.
Maximum possible effort
Workers best response function

0.8
Effort per hour
22
0.5
Feasible set
Reservation
wage
12
20
Hourly wage, $
Figure 5. The workers best response to the wage.

Think of the best response function as the answer to a hypothetical if-then?
question. It gives the answer to: If the wage is $8 what effort will the worker put in?
as well as to the identical question for all other possible wages that the firm might
offer. It is a best response function because it is the employees best way to respond
to the employers wage offer, taking into account the things that the wage will allow
the employee to buy, how unpleasant it is to work at each effort level, the probability
of getting fired when working at each effort level, and the consequences of getting
fired.

What is the lowest wage that will motivate the worker to provide any on the job effort
at all? To answer this, think about the wage that is so low that the worker just doesnt
care if he or she is fired, so there is no motivation to exert effort. This so-low-thatyou-dont-care wage is referred to as the workers reservation wage. It is the workers
reservation option. It is how much the worker values the next best alternative, taking
everything into account, which in this case is losing the job, getting unemployment
insurance while searching for a job, and then returning to another job. This is the
wage at which the best response function hits the horizontal axis. The reservation
option here has exactly the same meaning as Angelas reservation option in Unit 5.
DISCUSS 3: AN ECONOMY WITHOUT UNEMPLOYMENT BENEFITS

Where would the workers best response function cross the horizontal axis if there
were no unemployment benefits? How can this be interpreted?
The workers best response function rises as the hourly wage increases: the worker
works harder when the wage is higher because a higher wage means the cost of job
loss is higher. Look back at Figure 4. If the wage were $13 instead of $12 the blue
rectangle representing Juans employment rent would be larger.
But the best response function also becomes flatter as it increases. This is because, as
the level of effort approaches the maximum possible, the disutility of effort becomes
very great and so it takes a larger employment rent (and hence a larger wage) to
induce effort from the worker. Just like the production functions of the student and
farmer in Unit 3, an employer who pays the worker a high wage faces diminishing
marginal returns. In other words, the higher the initial wage, the smaller the increase
in effort the firm gets from a $1 per hour increase in wages. For example, a small
wage increase from $8 to $12 per hour increases effort from 0.15 to 0.5. At that point,
however, it takes a much larger wage increase, from $12 to $20 per hour, if the firm
wishes to increase effort by just a small amount (from 0.5 to 0.8). To discover the
properties of a workers best response function using calculus, see LEIBNIZ 9.
If we pick a particular wageeffort combination on the workers best response
function, we can think about the size of the workers employment rent. The shaded
blue area in Figure 6 shows the workers employment rent for the combination at
point Z in Figure 5, where wages are $12 per hour and effort is 0.5.
23
Unemployment
benefit plus the
disutility of effort
Unemployment
benefit
What worker gets should they not lose their job today
What worker gets should they lose their job today
12
Wage
Hourly wage, $
24
Workers rent when employed
Disutility associated with

providing effort of 0.5
Net benefit
from working
Opportunity cost of
working (providing
effort at 0.5)
What worker receives in

unemployment benefit during
his period of unemployment
0
Weeks
44
Expected duration
of unemployment
Figure 6. The workers employment rent when wages are $12 per hour.
6.8 WAGES, EFFORT AND PROFITS
the owners and managers know that they cannot get the worker to provide
more effort than is given by the best response function shown in Figure 5. The firm
can choose any wageeffort combination on (or to the right of) the best response
function. This is the firms feasible set when making hiring decisions and is shown by
the shaded red area. Any combination outside of the feasible set cannot be achieved
because the worker is not willing to provide that amount of effort for the wages
earned. The firm will always choose a combination on the boundary of the feasible
set (on the best response function) because it gets the highest effort possible for the
wage it pays.
To decide on the wage, managers and owners use the firms profit equation:

The profit equation shows it is preferable for the firm to pay low wages and to hire
workers who can produce the most output in their allotted work hours. Can a firm
simultaneously achieve these goals? No. The workers best response function in
Figure 5 shows that a firm that pays low wages will get low effort from workers,
which will reduce the amount they produce per hour. In other words, the firm has to
balance the trade-off between effort and wages to maximise its profits.
The firm thinks about the employees effort just as it thinks about any other input.
When it is purchasing an input, say a chemical used in its production process, it finds
the supplier that provides the greatest quantity for a given expenditure. That is, it
looks for the lowest price at which the chemical can be acquired. In the same way,
the firm is looking for a way to maximise the amount of effort the employee provides
for the wages paid. Notice this does not mean that the firm is trying to pay the lowest
possible wage, because if it did these workers might not put in any effort at all. So the
firm wants the cost of effort to be a slow as it can be. It maximises what we will call
the e/w ratio:
e/w = (effort performed/wages paid)
In Figure 7, along the blue line there is the same e/w ratio. Points on the line, like e =
0.45 and w = $10 have the same e/w ratio as e = 0.9 and w = $20, and the same is true
for all of the other points on the line. Why do profits stay the same along any one of
these lines and why do they slope upward?
Higher profits
(but infeasible)
Maximum feasible profits

Slope = effort/wage
Effort per hour
0.9
Workers best
response function
0.7
Lower profits (the

firm can do better)
0.6
0.45
Reservation
wage
10
13
20
Hourly wage, $
Figure 7. The firm sets the wage.

Concentrate on the middle blue line. It is upward-sloping because higher wages are
bad for profits, whereas higher effort is good for profits. To see this, think of the
effect on profits of a small fall in effort; for the firms profits to stay the same, the
firm must compensate by paying a lower wage. We can call this an isoprofit curve
25
26

because along the line, the higher cost of lower effort is exactly offset by the lower
wage set by the firm, and the firms profits stay the same (Remember from Unit 2 that
iso is from the Greek meaning equal: the isosceles triangle has two sides of equal
length).
As far as the firm is concerned, if it could get e = 0.9 by paying $20 and e = 0.45 by
paying half that amount; owners and managers would be equally happy, as profits
would be the same at either of these points. This line is an indifference curve for the
them, assuming that all they care about is the level of profit.
Now look at the two additional isoprofit lines on Figure 7. Along each line there is a
given level of profit; but some lines are better for the owners than others. The slope
of the line is the e/w ratio. Steeper lines mean a lower cost of effort for the firm.
Think about a small fall in effort: if this is associated with a bigger fall in the wage
than before, the isoprofit line will be steeper. Since the firm is paying less than before
for a given fall in effort, its profits will be higher.
To maximise profits the firm will seek to get onto the highest isoprofit line possible,
but it cannot simply choose the wage and effort level, because the worker chooses
the latter. Because the firm cannot dictate the level of effort, it has to pick some
point on the workers best response function, and the best one will the one which is
just touching but not crossing (that is to say, tangent to), the workers best response
function.
This is similar to individuals trying to maximise their utility in Units 3 and 5. There
the aim was to get on to the highest feasible indifference curve by choosing the
indifference curve that was tangent to the feasible consumption frontier. In the case
here its the firm making the choice. It wants to get on the steepest isoprofit curve
that is feasible. The feasible set here is defined by the employees best response
function; the amount of effort (and hence output of the required quality) that will be
produced at a given wage.
In the case in Figure 7, the firm will choose point A, offering a wage of $13 per hour
and hiring a worker who will exert effort of 0.6. The firm cannot do better than this
point. Take point B, on an isoprofit line with higher profits. The worker would take
the job for $10 per hour but would not be willing to provide effort of 0.7 for that
wage. Hence, point B is infeasible and point A gives the firm the maximum feasible
profit. LEIBNIZ 10 shows you how to find the profit-maximising wage for a firm,
using calculus..
6.9 THE FIRM, ITS EMPLOYEES AND UNEMPLOYMENT
above we defined the best response function as showing how the worker will
respond to each of the firms possible wages taking into account:
1. How important to the employee are the things that can be bought with the wage?
2. How unpleasant is it to work at each level of effort?
3. The probability of getting fired when working at each effort level.
4. The consequences of getting fired.
If there are changes in any of these, the best response function will either shift to the
right (it takes a higher wage to motivate the worker to work the same amount) or to
the left. Shifts to the left are obviously good for the owners of the firm, because they
can then get the same amount of effort for a lower wage. Whether the best response
function shifts right or left in response to a change in one of the items in the above
list depends on whether the change decreases the employment rent that the worker
would get at each wage (shifts right) or increases the rent (shifts left). Remember, the
employment rent is a measure of the cost of losing the job.
From Figure 4 we already know that a rise in the expected duration of unemployment
increases the employment rent and hence will will shift the workers best response
function to the left, because the consequences of losing a job become worse. When
the cost of a spell of unemployment rises the worker will be willing to put in more
effort for a given wage. Figure 8 shows how the best response function shifts left, if
jobs become harder to findmeaning that, after losing a job, workers expect to be
unemployed for longer.
Figure 4 also shows that an increase in the level of unemployment benefit decreases
the employment rent (job loss is not as costly). A rise in unemployment benefit will
shift the workers best response function to the right.
If we choose a given hourly wage, say $18, we can see that workers put in different
levels of effort when there are changes in the level of unemployment and the
unemployment benefit. Or if we choose a level of effort, say 0.6, and ask how much
wage the firm would have to pay to get the worker to provide that amount of work, we
see that it has to pay less if unemployment increases, and more if the unemployment
benefit increases.
27

1
Best response function (with
increased unemployment)
Status quo best response function
0.85
0.75
Effort per hour
28
Best response function (with

increased unemployment benefit)
0.6
0
Reservation
wage with more
unemployment
18
Reservation wage
with higher
unemployment benefit
Status quo
reservation
wage
Hourly wage, $
Figure 8. The best response function depends on the level of unemployment and the
DISCUSS 4: EFFORT AND WAGES

A firm faces the best response functions shown in Figure 8. It would like to elicit a
level of effort of 0.75. In each case of the three cases shown, explain why the wage
differs.
DISCUSS 5: DURATION OF UNEMPLOYMENT

To this point, we have been used figures with effort on the vertical axis and
hourly wage on the horizontal axis. What would the workers best response curve
look like if we instead chose a given wage, say $12 an hour, and let the expected
duration of unemployment vary, putting it on the horizontal axis instead of the
wage? What would happen to this curve if the given wage increased to $14? What if
unemployment benefit were raised?

These changesgreater duration of job loss, or increase in the unemployment
benefitaffect the best response function because they alter the reservation option
and the distribution of bargaining power between the firm and the employee. When
the expected duration of unemployment rises, workers lose bargaining power,
whereas they gain bargaining power when the unemployment benefit rises. Any
change that increases the workers bargaining power will motivate the firm to pay
a higher wage for a given level of effort. This is similar to the new legislation that
Angela introduced in Unit 5, which gave her more bargaining power in negotiations
with her landlord Bart.
It is also similar to the Ultimatum Game. Think how the game would be affected
with a small change in the rules. In the new version of the Ultimatum Game, if the
Responder rejected the Proposers offer of a split of the pie, instead of both getting
nothing the Responder would be able to play another game with a different Proposer
immediately. This would be like the employee of the firm knowing that, if fired, it
would be easy to get another job from a different employer (short unemployment),
and so the employee would offer little effort for any wage.
Or suppose the Ultimatum Game responder knew that rejecting the proposers offer
would not mean a reward of zero, but instead some amount from the experimenter.
This guaranteed transfer from the experimenter is now the new reservation option.
This improvement in the reservation option, like a generous unemployment benefit
for the employee, would provide additional motivation for the responder to reject low
offers as being unfair: protesting unfairness would be less costly. And, likewise, the
employee with the reservation option of a high unemployment benefit would not be
willing to work as hard.
6.10 FAIRNESS AND FAVOURS
the best response function can also shift due to changes in firm policy about
things other than wages (as shown in Figure 9). We saw when discussing Figure 4
that if the managers improve working conditions by providing some amenity that
the worker values the job will be more valuable to the worker, who will work harder
for any given wage. The example we gave was air conditioning, but the amenity
could also be flexible work hours or free drinks after work on Fridays. The improved
amenities increase the employment rent and so shift the best response function to
the left. The firm now needs to pay less for a given amount of effort.
29

Best response function (worker
reciprocates employers flexible hours
policy by providing more effort)
Status quo best response function
Best response function (worse
working conditions make work
more unpleasant for worker)
Effort per hour
30
0
Reservation
wage with
worker
reciprocation
Status quo
reservation
wage
Reservation
wage when
working conditions
are worse
Hourly wage, $
Figure 9. The best response function depends on fairness and working conditions.
The disutility of effort may also be affected by an employees feelings about the
company, or its owners and managers. We know that from the Ultimatum Game in
Unit 4 that people care about being treated fairly. If other similar firms have recently
raised their wages and the employees firm has not, it is likely that workers will
regard their wages as unfair. This, in turn, will increase the disutility of working for
the company, resulting in a shift to the right in the best response function. At any
given wage, the employee will work less hard.
6.11 TRADE UNIONS AND WAGE SETTING
improved macroeconomic conditions (meaning a reduced duration of

unemployment if workers lose a job) or more generous unemployment benefits are
not the only way that employees may gain bargaining power. A trade union is an
organisation that can represent the interests of a group of workers in negotiations
with employers over issues such as pay, working conditions and working hours.
Unions can be influential at the firm, industry or economy level. A union can
threaten to strike, which gives it bargaining power in negotiations with employers.
Thus it may be the trade union rather than the firm that sets the wage, or more likely
some negotiation between the two.

When the union negotiates the wage with the firm, the firm no longer sets the wage
that maximises its profits at the tangency of the isoprofit line and the best response
function as in Figure 7 and point A in Figure 10. The wage will be higher than that
preferred by the firm and profits lower (indicated by the flatter isoprofit line passing
through C).
Isoprofit
line (no union)
Effort per hour
0.9
0.85
0.6
Best response function

(with union voice
effect)
Isoprofit line (union wage and

union voice effect)
D
C
Best response function

(no union)
Slope of isoprofit
line = effort per
wage unit
Isoprofit line
(union wage only)
0
Reservation Reservation
wage with union wage when
voice effect
no union
Employers profit
maximising wage
(no union)
Union
wage
Hourly wage, $
Figure 10. Union wages and voice effect.

Lets consider the case of a firm that, before a trade union was organised, chose
point A in Figure 10, at which its isoprofit line is tangent to the workers best
response function. Now the workers decide to form a trade union and their elected
representatives bargain with the firm over the wage. They have sufficient bargaining
power so that, after negotiating, the firm agrees to set a higher wage than it would
have preferred at point C on the light blue, flatter, isoprofit line. This will reduce the
profits of the firm because the isoprofit line that intersects with point C is less steep
than the profit-maximising isoprofit line. Remember that the slope of the isoprofit
line is equal to the effort per wage unit. If nothing else had changed, the intervention
of the union has resulted in the firm being forced into accepting a position where it
receives less effort from workers for each dollar that the firm spends on wages.
However, workers may interpret the firms recognition of the trade union, and its
willingness to compromise with them over a higher wage, as a sign of goodwill. As
a result they might identify more strongly with their firm, and experience effort
as less of a burden than before, shifting the best response function to the left. The
result of the greater bargaining power of the workers, and their reciprocation of the
companys worker-friendly policy, is shown as point D in the figure.
31
32
DISCUSS 6: OUTSOURCING COMES HOME

At the start of this unit we discussed the decision by many clothing companies to
outsource production to Bangladesh and other low-wage economies.
1. Use the diagram with the wage on the horizontal axis and effort on the vertical
axis to show the best response function of the workers in the high wage home
country. In the same diagram show the best response function of workers in the
foreign low wage country. Assume that there are no unions in either economy and
that wages are measured in dollars in both cases.
2. What wage does the firm set in the absence of the possibility of outsourcing? What
wage does the firm set if it switches production to the low wage country (ignore
the costs of moving production)?
3. How do you think the threat of outsourcing might affect the wage set by the firm
in the home country and why? Show this in a diagram.
6.12 ANOTHER KIND OF FIRM
a minority of firms have an entirely different structure to the one we have been
analysing: their workers, to whom the managers are responsible, own the firm. One
well-known example is the large British retailer John Lewis, 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
employeespension, paid holidays, long-service sabbaticals, social activities
are generous; and the businesss profits are shared out as a bonus, calculated as a
percentage of each persons 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 countrys most profitable and consistently
successful retail businesses.
Worker-owned firms are hierarchically organised, 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 firms are that the cooperative firms, as they are sometimes
called, 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 firms
are as productive, or more so, than their conventional counterparts.
Inequalities in wages and salaries within the firmfor example between managers
and production workersare also typically less in worker-owned firms than in
conventional firms. Worker-owned firms also 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. But borrowing the
funds to start and sustain worker-owned companies is often difficult because, as we
will see in Unit 11, banks are often reluctant to lend funds (except at high interest
rates) to people who are not wealthy.
PAST ECONOMISTS
JOHN STUART MILL

John Stuart Mill (1806-1873), one of the most
important philosophers and economists of
the 19th century, thought that the structure
of the typical firm was an affront to freedom
and individual autonomy. In The Principles
of Political Economy (1848), Mill described
the relationship between firm owners and
workers as an unnatural one: To work at the
bidding and for the profit of another, without
any interest in the work is not, even when
wages are high, a satisfactory state to human
beings of educated intelligence, he wrote.
Attributing the conventional employeremployee relationship to the poor education
Source: The Popular Science Monthly
of the working class, he predicted that
the spread of education, and the political
empowerment of working people, would change this situation: The relation of
masters and work-people will be gradually superseded by partnership perhaps
finally in all, association of labourers among themselves.
33
34
DISCUSS 7: A WORKER-OWNED COOPERATIVE

In Figure 1 we showed the actors and decision-making structure of a typical firm.
How do the actors and decision-making structure of John Lewis differ from that of a
typical firm? Redraw Figure 1 to show this.
6.13 THE FIRM AND ITS EMPLOYEES IN THE ECONOMY
we can now broaden the perspective from a single firm to the economy as a
whole. As we have seen, the fear of job loss is a powerful motivation for workers.
The firms owners and managers make use of this to incentivise workers to work
hard. To extend this result to the economy as a whole, we ask how changes in
the unemployment rate affect the wage set by firms: because although there is a
disutility of exerting effort at work, the cost of job loss is considerably higher. Unit
12 examines the way economists have estimated the psychological, as well as the
financial, costs of unemployment.
In Figure 11 the employment rate in the economy is on the horizontal axis. You will
see that it goes up to a value of 1. The employment rate is defined as the proportion
of people of working age, usually defined as those between 16 and 64, who are
employed. There is a vertical line at a value of the employment rate less than one.
This is labelled labour force. Between the labour force line and the employment rate of
one is the proportion of people of working age who are neither working nor actively
looking for work; they are referred to as inactive, or out of the labour force.
35
Wages
Labour
force
Wage curve
0
0.5
5%
Employment rate
12%
Unemployment
Figure 11. The wage curve: labour discipline and unemployment in the economy as a whole.
The upward-sloping line is called the wage curve. The wage curve translates the
firm-level labour discipline model into a way of viewing an important relationship
between wages and unemployment in the economy as a whole. The way to do this
is to first take a high unemployment rate, such as 12%. The unemployment rate is
the proportion of the labour force who are not employed. At 12% unemployment
the workers cost of job loss is high, because it will be harder to find another job,
and so unemployment is likely to last for longer. As a result, the worker will put in
a high level of effort for a relatively low wage. The firms profit-maximising wage is
therefore low. We can also relate this back to Figure 8, where we showed that a higher
unemployment rate shifts the workers best response function to the left. As a result,
the firm sets a lower wage. This is shown in Figure 11 by the lower wage at the high
unemployment rate.
At 5% unemployment the workers cost of job loss is low and the worker will put in
a low level of effort for a low wage. The firms profit-maximising wage is therefore
higher. This is shown in Figure 11 by a higher wage at the low unemployment level.
The effect of unemployment on effort levels leads firms to raise the wage as the
unemployment rate falls, and is the reason for the wage curve sloping upward.
As we see in Unit 14, we can also translate the other influences on the effort-wage
trade-off, such as the level of the unemployment benefit and the institutional
structure of union wage bargaining, into the wage-curve diagram. These aspects of
economic policy and institutions will shift the wage curve. For example, a higher
unemployment benefit reduces the cost of job loss and shifts the wage curve upward.
When unions use their bargaining power in wage negotiations, a higher wage is set
for a given unemployment rate. In Unit 14 we also show how to use the wage curve
36

to explain persistent differences in unemployment across countries. The wage curve
will also be useful in explaining how governments can use a range of supply-side
policies that affect bargaining power in the firm to influence unemployment.
Two other implications of the way the firm works relate to booms and recessions in
the economy. When the economy is in a recession, unemployment is high; when it is
in a boom, unemployment is low. High unemployment in a recession increases the
cost of job loss: employment rents go up because the value to the worker of a job is
higher. And if employment rents were higher, we would predict that employees work
harder, and exert more effort for a given wage. This is exactly what happened in a
large company in the US following the global financial crisis.
Edward Lazear (an economic advisor to former US President George W. Bush) and
his co-authorsinvestigated a single firm during the global financial crisis, to see
how the managers and workers reacted to the turbulent economic condition. The
firm specialises in technology-based services, such as insurance-claims processing,
computer-based test grading and technical call centres, and operates in 12 US
states. The nature of the work made it easy for the management of the firm to
track the productivity of workers. It also allowed Lazear and his colleagues to use
the firms data from 2006-2010 to analyse the effect on worker productivity of the
worst recession since the Great Depression. They found that productivity increased
dramatically during the financial crisis, and that this was more due to workers
putting in more effort than the management letting go the least productive members
of the workforce. The severity of the recession raised the workers cost of job loss
and they were therefore willing to work harder. In the model we have developed,
we would predict that the best response function shifts to the left as a result of the
recession and that the firm would have responded to this by choosing a lower wage
(add the isoprofit curves to Figure 8 to see this); but the firm did not substantially
lower its wages.
An earlier recession provided another insight, which helps to explain this surprising
result. Another economist, Truman Bewley was puzzled when he saw only a
handful of firms in the northeast of the US cutting wages during the recession of
the early 1990s. Most firms, like the one the Lazear team studied, did not cut their
wages. Economic logic dictates that firms could have cut wages while sustaining an
employment rent sufficient to motivate hard work.
Bewley interviewed more than 300 businesspeople, labour leaders, business
consultants and careers advisors in the northeast of the US. He found that employers
chose not to cut wages because they thought it would hurt employee morale,
reducing productivity and leading to problems of hiring and retention. They thought
it would ultimately cost the firm more than the money they would save in wages. If
workers view the employer as being unfair, this could raise the disutility of work and
shift the best response function to the right. Worker effort would fall and the firm
would lose. Employers thought it was better to lay off some workers and keep wages
the same: those who stay feel lucky to have a job, and will be willing to work a little
harder, as observed by Lazear.
6.14 CONCLUSION
the wage curve, and the empirical studies of the effects of recessions on wage
cutting and worker effort, indicate that the firm as an actor affects the entire
economy. To understand the firms role in the economy, we view the firm not only
as an actor, but also a stage on which the actors that make up each firmowners,
managers, and employeesinteract.
The three sets of actors come together in the firm because they expect to be better off
participating in the firm than they would be otherwise. And they are better off. We
have already seen that workers earn economic rents, so they are doing better than
they would without the job. The same is true of managers. Owners of the firm are of
course making sufficient profits to continue to invest in this firm, instead of moving
their funds elsewhere.
But wherever there are mutual gains to be had, there will be conflicts over the
distribution of these gains. There are conflicts of interests between the owners
(greater profits) with those of the managers (greater salaries, first class air travel)
and the interests of the employees (higher wages, a safe work environment or a less
punishing pace of work).
In Unit 3 we saw that, for an individual farmer or student deciding on how hard to
work, conflicts can arise between the individuals objectives that require them to
trade free time for more goods or more grades. We asked if the farmer or student is
doing the best possible under these constraints? If the answer was no, then only the
individual suffered.
But in Units 4 and 5, and also in this unit, conflicts arise between people. These
conflicts are unavoidable because what each person receives depends on what
another person does, and gets. In the Public Good game in Unit 4, for example,
payoffs depend not only on how much you contribute to the public good, but also
how much others contributed. If in this case others are selfish, and do not contribute,
then you have a conflict of interest with them. Similarly Bart and Angela had a
conflict of interest because Bart could keep some of what Angela produced: there was
a conflict about how much she would produce, and how much Bart would get as a
result.
In the firm, what the owners receive depends on what the managers and employees
do, and the same is true of what the managers and employees receive. Managers
determine what will be done with other peoples money, and with other peoples
effort.
37
38

As in previous units, the institutions governing the relationships among the firms
actors, and the firms relationship with the rest of the economy, decide whether the
possible gains from exchange are fully realised and fairly distributed. We have seen
that the wage rate and effort provided by an employee, for example, will depend on
the bargaining power of the employees, the managers and owners, and therefore
will be affected by the extent of unemployment and unemployment insurance in the
economy. The bargaining power of managers decides whether they will implement
the owners desires to maximise profits, or prioritise their own objectives. This will
be affected by rules governing the kinds of information that managers must make
public, and the laws governing the selection and replacement of management by
owners.
The success of a firm is measured by how fully these mutual gains are realised, and
how fairly the gains are distributed among the firms actors.
UNIT 6 KEY POINTS
1. When people specialise in different tasks in producing a given commodity, and also in
the production of different commodities, this is called the division of labour.
2. There are two main ways that the products of peoples specialised labour get
transferred from the producer to others (whether consumers or other producers):
markets and firms.
3. The distribution of mutual gains of the three sets of actors in the firm will depend on
the balance of bargaining power among them.
4. Whenever there are economies of scale, the cost savings from greater firm size can
arise from engineering benefits, greater ability to specialise and the presence of
fixed costs. Diseconomies of scale can limit firm size when firms get too large and it
becomes costly to coordinate, or they cannot respond qiuckly to changes.
5. The contract between the employee and the firm is incomplete. It specifies a wage
and other conditions, but it does not specify exactly what the worker is to do from day
to day or how hard she is to work. As a result, the firm cannot purchase the employees
work activities in the same way that it purchases other inputs like electricity or raw
materials.
6. The workers employment rate measures how much better off the worker is having the
job than she would be were she to lose her job and therefore receive her reservation
option. Employment rents exist because most firms do not try to pay the lowest
possible wage; instead they pay workers more than the minimum in order to make
the cost of job loss high enough so that along with the workers other motiviations,
she will work hard. Because finding and training good new workers is costly, firms are
willing to offer workers a rent, both to recruit them and to keep them from leaving.
7. The wage rate chosen by the firm will depend on the bargaining power of workers
versus owners and managers, as well as the reservation option of the worker. It is
therefore affected by the extent of unemployment benefit in the economy, as well as
other factors, such as the presence of unions.
8. The wage curve represents the relationship between wages and unemployment in
the entire economy. The curve is upward-sloping, highlighting the fact that the firms
have to pay workers a higher wage to address the triple problems of motivation,
recruitment and retention when unemployment is low and the cost of job loss is small.
39
40

UNIT 6: READ MORE
INTRODUCTION
Organisations and markets
Read economist Herbert Simons discussion of firms and markets: LINK
Simon, H. A. 1991. Organizations and Markets. Journal of Economic Perspectives, 5(2), pp.
25-44.
6.1 THE FIRM: AN ACTOR AND A STAGE
What are firms, and how do they work?
The firm rivals the government in importance among the institutions of modern
capitalist economies. In A short history of a revolutionary idea John Micklethwait
and Adrian Wooldridge explain how this came to be. Louis Putterman and Randall
Kroszner summarise the subject, and competing views.
Micklethwait, J. and Wooldridge, A. 2005. The Company: A Short History of a
Revolutionary Idea. Modern Library.
Putterman, L. and Kroszner, R. 1996. The Economic Nature of the Firm: A Reader.
Cambridge: Cambridge University Press.
6.2 FIRMS AND FLASH MOBS
Ownership
Henry Hansmann and Oliver Williamson describe the property rights, authority
structures and market interactions among managers, owners, employees, suppliers
and customers.
Hansmann, H. 1996. The Ownership of Enterprise. Cambridge, MA: Harvard University
Press.
Williamson, O. E. 1985. The Economic Institutions of Capitalism. New York: Free Press.
Ronald Coase on the economics of the firm
The economics of the firm owes more to Ronald Coase than to anyone else.
Coase, R. H. 1992. The Institutional Structure of Production. American Economic Review,
82(4), pp. 713-19.
Coase on the firm: LINK.
Coase, R. H. 1937. The Nature of the Firm. Economica, 4, pp. 386-405.
6.5 OTHER PEOPLES LABOUR

Piece rates
Helper, S., Kleiner, M. M. and Wang, Y., 2010. Analyzing Compensation Methods in
Manufacturing: Piece Rates, Time Rates, or Gain-Sharing? National Bureau of Economic
Research working paper, No. 16540.
6.6 EMPLOYMENT RENTS AND WORK
Conf lict
Labour economists Alan Krueger and Alexandre Mas unravel the mystery of why
the tread on Bridgestone/Firestone tyres was separating, endangering motorists
and reducing profits. Barbara Ehrenreich worked undercover for minimum wage in
motels and restaurants to see how Americas poor live. Harry Braverman provides a
history of what he calls the deskilling process, and suggests how dumbing down
jobs is a strategy for maximising the employers profits.
Krueger, A. and Mas, A. 2004. Strikes, Scabs, and Tread Separation: Labor Strife and the
Production of Defective Bridgestone/Firestone Tires. Journal of Political Economy, 112(2),
pp. 253-89.
Ehrenreich, B. 2001. Nickel and Dimed: On (not) getting by in America, Barnes and Noble.
Braverman, H. 1974. Labor and monopoly capital: the degradation of work in the twentieth
century. New York: Monthly Review Press.
Job displacement
The research on the effects of job displacement: LINK.
Kletzer, L. 1998. Job Displacement. Journal of Economic Perspectives, 12(1), pp. 115-36.
Also:
Couch, K. and Placzek, D. 2010. Earnings Losses of Displaced Workers Revisited. American
Economic Review, 100(1), pp. 572-89.
6.12 ANOTHER KIND OF FIRM
Other kinds of firm
Economist John Pencavel explains why a group of cooperatives were more productive
than their competitors. The Cathedral and the Bazaar shows how entirely new forms of
firms, neither capitalist nor worker-owned either, are springing up in the knowledgebased economy.
Pencavel, J. 2002. Worker Participation: Lessons from the Worker Co-Ops of the Pacific
North-West. New York: Russell Sage Foundation.
Raymond, E. 1999. The Cathedral and the Bazaar. Sebastopol, CA: OReilly.
41
42
6.13 THE FIRM AND ITS EMPLOYEES IN THE ECONOMY

Making do with less
Lazear, E. P., Shaw, K. L. and Stanton, C., 2013. Making Do With Less: Working Harder
During Recessions. National Bureau of Economic Research working paper, No. 19328.
Why wages dont fall
Bewley, T. F., 1999. Why wages dont fall during a recession. Harvard University Press.
CONCLUSION
The social responsibility of business
How should firms balance the objective of social responsibility with the objective of
maximising profits? LINK.
Friedman, M. 1970. The Social Responsibility of Business Is to Increase Its Profits. New
York Times, September 13.
MORE
The company of strangers
Paul Seabright on how market economies manage to organise complex trades and a
division of labour among strangers.
Seabright, P. 2010. The company of strangers: A natural history of economic life. Princeton
University Press.
This work is licensed under the Creative Commons Attribution-NonCommercialNoDerivatives 4.0 International License. To view a copy of this license, visit http://
creativecommons.org/licenses/by-nc-nd/4.0/ or send a letter to Creative Commons,
444 Castro Street, Suite 900, Mountain View, California, 94041, USA.

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THE FIRM AND ITS

Courtesy of National Archives, USA

THE ROLE OF THE FIRM IN THE ECONOMY AND THE INTERACTION

coreecon | Curriculum Open-access Resources in Economics

UNIT 6 | THE FIRM AND ITS EMPLOYEES

6.1 THE FIRM: AN ACTOR AND A STAGE

apple, samsung, american apparel and toshiba are business

coreecon | Curriculum Open-access Resources in Economics

6.2 FIRMS AND FLASH MOBS

Figure 1. The firms actors and decision-making structures.

UNIT 6 | THE FIRM AND ITS EMPLOYEES

coreecon | Curriculum Open-access Resources in Economics

6.3 BIG IS BEAUTIFUL (OR AT LEAST PROFITABLE)

e. f. schumachers Small is Beautiful, published in 1973, advocated small-scale

Number of employees (millions)

Figure 2. Firm size in the United States: number of employees (1900-2006).

UNIT 6 | THE FIRM AND ITS EMPLOYEES

DISCUSS 1: FALL OF FORD

coreecon | Curriculum Open-access Resources in Economics

EINSTEIN: THE SIZE AND COST OF A PIPE

UNIT 6 | THE FIRM AND ITS EMPLOYEES

TEST YOUR UNDERSTANDING

6.4 OTHER PEOPLES MONEY: THE SEPARATION OF OWNERSHIP AND CONTROL

coreecon | Curriculum Open-access Resources in Economics

UNIT 6 | THE FIRM AND ITS EMPLOYEES

6.5 OTHER PEOPLES LABOUR

coreecon | Curriculum Open-access Resources in Economics

DISCUSS 2: BUYING SHARES, HIRING WORKERS

UNIT 6 | THE FIRM AND ITS EMPLOYEES

6.6 EMPLOYMENT RENTS AND WORK

coreecon | Curriculum Open-access Resources in Economics

UNIT 6 | THE FIRM AND ITS EMPLOYEES

coreecon | Curriculum Open-access Resources in Economics

UNIT 6 | THE FIRM AND ITS EMPLOYEES

Marias rent when employed

Disutility of effort when employed

0 What Maria gets

coreecon | Curriculum Open-access Resources in Economics

UNIT 6 | THE FIRM AND ITS EMPLOYEES

What Juan gets should he not lose his job today

Juans rent when employed

What Juan receives in unemployment

coreecon | Curriculum Open-access Resources in Economics

WHEN ECONOMISTS AGREE

UNIT 6 | THE FIRM AND ITS EMPLOYEES

6.7 EMPLOYMENT RENTS AND EMPLOYEE EFFORT

coreecon | Curriculum Open-access Resources in Economics

Workers best response function

Effort per hour

Figure 5. The workers best response to the wage.

UNIT 6 | THE FIRM AND ITS EMPLOYEES

DISCUSS 3: AN ECONOMY WITHOUT UNEMPLOYMENT BENEFITS

coreecon | Curriculum Open-access Resources in Economics

Workers rent when employed

Disutility associated with

What worker receives in

6.8 WAGES, EFFORT AND PROFITS

UNIT 6 | THE FIRM AND ITS EMPLOYEES

Maximum feasible profits

Effort per hour