IO Chapter 3

Review of problem we did at the end of last period. How to maximize? 1. set up the problem. = TR - TC = p(q)*q - C(q) 2. get first order conditions (FOC). ie take derivative with respect to q. 3. Set the derivative equal to 0. 4. Solve for unknowns.

Then the next question is: are economists making the right assumption when they assume that firms maximize profits? Do you think this is a reasonable assumption?

As our textbook points out, there may be various problems with the assumption of profit maximization. First there is the question: do managers and stock holders have the same objectives? Second, when there are many small stockholders, how can they act to assure profit maximization? Third, do all the participants have the same information?

One way of solving these problems is to give managers contracts which assure that their interests are similar to the stock holders (for instance stock options.) Another way is to have a board of directors, including members who are 'outsiders.'

Other factors which may assure that managers perform in the share holders best interests - 1. the labor market - managers do not want to get a negative reputation, because they will eventually be seeking another job; 2. product market - firms may be unable to survive in competitive areas, unless they maximize profits and this gives managers incentive or lose their job; 3. capital market - managers who do not maximize profits risk being bought out, when other firms see that potential profit exists.

Notice: whose interests are NOT taken into consideration by either stock holders nor managers? Laborers.

Another question is how large should firms be? What is the optimal size? Can divide size in terms of horizontal and vertical extension. Horizontal refers to the production (or sale) of the same product. For instance when one bank buys out another one this is horizontal expansion. Vertical involves stages of production. For instance when a car company buys a steel company.

The optimal horizontal size has to do with the shape of the long run cost function. Empirical evidence suggests the cost function has a flat bottom (saucer shaped). Also, there is a difference between optimal plant size and firm size (remember we discussed the fast food industry last time. The optimal 'plant' or store, may be quite small, but the optimal size of the corporation - with branches throughout the country, or even the world, might be very large.)

Vertical integration varies a lot by type of product. For instance, why is the garment industry not very vertically integrated, while the car industry is? Can you think of other examples where it makes sense to integrate, and others where it doesn't? For instance, should firms provide food to workers, or buy catering services?

Should a firm makes its own inputs, or buy them? Does a production process have firm specific assets? The book mentions Fisher body as an example. Fisher was an early manufacturer of car bodies. The original bodies were made of wood and were interchangable. Metal bodies had to be made for particular cars and so a firm which invested in machinery to make a particular auto makers' bodies probably couldn't make other cars. Eventually GM bought Fisher bodies.

The Rouge River plant is another example of vertical integration.

Then there is the example of Kaiser, who may represent the ultimate in vertical integration. Kaiser started in road construction and then went on to build ships. While building ships in California he decided to produce his own steel, rather than relying on Pennsylvania steel companies to supply it. He also built the Hoover dam and a number of other construction projects in remote locations, and while doing so was concerned about the provision of health care for his workers, so he found a group of doctors who agreed to provide health care on a prepaid basis, thus the beginning of the prepaid health care plan and more precisely Kaiser Permanente. Although his fame as an industrialist has been lost, his ideas about affordable health care live on.

Why might Kaiser have been concerned about the health care of his workers? Is his behavior consistent with profit maximization? He argued that is was, since unhealthy workers were unproductive workers. Kaiser also allegedly went from being anti-union to pro-union, with the argument that a unhappy worker is an unproductive one. (As mentioned in the book, one thing economists still don't know a lot about is why there is so much variation across firms. This includes differing attitudes about unions. More generally some firms seem more concerned about worker morale and well-being while other actively seem to undermine worker well-being.)

While there may be clear cases where vertical integration is preferred, maintaining quality control becomes a problem. Sometimes firms obtain inputs both from subsidiaries (owned by the same parent company) and independent suppliers. This maintains some competition, even for the internal supplier and is known as tapered integration.

Franchising is another way to balance vertical integration while maintaining profit motives.

The last question posed in the book is why firms are different. This is an area that economists still know very little about. Firms even in the same production area can vary in profit/managerial techniques/production processes, etc.

What keeps some firms competitive for a long period of time? Why can't firms just imitate more successful firms? Sometimes the legal environment actually protects firms from imitation. Also, history, firm culture, individual personalities etc. may contribute to a firm's success. There has been quite a bit of study of Japanese/European and US management styles and attempts by US firms to mimic Japanese and European models which involve more worker decision making (less top down management), but these have not always worked in the US, probably because US workers and managers have different attitudes/histories to start with.