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Neither are employees. This division of revenue has an important implication. This is one reason we consider the firm as a stage, one on which not all the actors have the same interests. In small enterprises, the owners are typically also the managers and so are 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 maximize the profits of the enterprise by providing the kinds of food and ambience that 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. 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 general public, a company can raise capital to finance its growth, leaving strategic and operational decisions to a relatively small group of specialized managers.

The decisions of managers affect profits, and profits decide the incomes of the owners. But it is not always in the interest of managers to maximize profits. They may choose to take actions that benefit themselves, at the expense of the owners.

Why Economists Disagree: An Introduction to the Alternative Schools of Thought

Perhaps they will spend as much as possible on their company credit card, or seek to increase their own power and prestige through empire-building, even if that is not in the interests of shareholders. Even single owners of firms are not required to maximize their profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But unlike managers, when they lose profits as a result, the cost comes directly out of their pocket. In the eighteenth century, Adam Smith observed the tendency of senior managers to serve their own interests, rather than those of shareholders.

He said this about the managers of what were then called joint-stock companies:. The Wealth of Nations , 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 incentivize managers to serve their interests.


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The board has the authority to dismiss managers, and shareholders in turn have the right to replace members of the board. The owners of large companies with many shareholders rarely exercise this authority, partly because shareholders are a large and diverse group that cannot easily get together to decide something. Occasionally, however, this free-rider problem is overcome and a shareholder with a large stake in a company may lead a shareholder revolt to change or influence senior management.

When we model the firm as an actor, we often assume that it maximizes profits. This is a simplification, but a reasonable one for most purposes:.

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.

Our focus here is how firms seek to minimize the cost of acquiring the necessary labour to produce the goods and services they sell. We have already seen in Unit 2 how firms might increase output without raising costs by adopting new technologies, and in Unit 7 we will study their sales decisions. Hiring employees is different from 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. But a firm cannot write an enforceable employment contract that specifies the exact tasks employees have to perform in order to get paid. This is for three reasons:. To understand the last point, consider a restaurant owner, who would like her 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 waiter because he had not smiled often enough. An employment contract omits things that both the employees and the business owner care about: how hard and well the employee will work, and for how long the worker will stay. Think of two or three jobs with which you are familiar, perhaps a teacher, a retail worker, a nurse, or a police officer. In each case, indicate why the employment contract is necessarily incomplete.

Adam Smith, writing at the birth of capitalism in the eighteenth century, was to become its most famous advocate. Karl Marx — , 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.

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In he became a writer and editor for the Rheinische Zeitung , a liberal newspaper, which was then closed by the government, after which he moved to Paris and met Friedrich Engels, with whom he collaborated in writing The Communist Manifesto Marx then moved to London in At first, Marx and his wife Jenny lived in poverty. He earned money by writing about political events in Europe for the New York Tribune.

Marx saw capitalism as just the latest in a succession of economic arrangements in which people have lived since prehistory. Inequality was not unique to capitalism, he observed—slavery, 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.


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  • This, he claimed, inevitably caused conflict between employers and workers. Buying and selling goods in an open market is a transaction between 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. Instead, the wage allowed the employer to rent the worker and to command workers inside the firm. Marx thought that the power wielded by employers over workers was a core defect of capitalism.

    Capital is long and covers many subjects, but you can use a searchable archive to find the passages you need. Marx also had influential views on history, politics, and sociology. He thought that history was decisively shaped by the interactions between scarcity, technological progress, and economic institutions, and that political conflicts arose from conflicts about the distribution of income and the organization of these institutions. He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities.

    These themes include the firm as an arena of conflict and of the exercise of power this unit , the role of technological progress Unit 1 and Unit 2 , and the problems created by inequality Unit Why is it not possible for firms just to pay employees according to how productive they are? This method of payment, known as piece rate , provides the employee with an incentive to exert effort, because employees take home more pay if they make more garments. In the late nineteenth century the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies.

    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? For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. For some employees, hard work is a way to reciprocate a feeling of gratitude to the employer for providing a job with good working conditions.

    In other cases, firms identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group that is divided among team members. But in the background, there is another reason to do a good job: the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security.

    In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly. If firms paid their employees the lowest wages they would be willing to accept, the answer would be no.

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    Such a wage would make the worker indifferent between remaining in the job and losing it. But in practice most workers care very much. There is a difference between the value of the job taking into account all the benefits and costs it entails and the value of the next best option—which is being unemployed and having to search for a new job. In other words, there is an employment rent. 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.

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    Demand and Supply at Work in Labor Markets – Principles of Economics

    For example, the two leading economists of the early nineteenth century—Ricardo and Malthus—were political opponents. Ricardo often sided with businesspeople, for example in supporting freer imports of grain to Britain to reduce food prices and allow lower wages.


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    • Malthus opposed him and supported the Corn Laws that restricted grain imports, a position favoured by the landed gentry. But the two economists both proposed 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 nineteenth century, Marx contrasted the way that buyers and sellers interact on a market, voluntarily engaging in trade, with how the firm is organized as a top—down structure, one in which employers issue orders and workers follow them.

      The nature of the firm , 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.

      Like Malthus and Ricardo, Coase and Marx disagreed. But like Malthus and Ricardo, they also advanced economics with a common idea. Recall that an economic rent measures the value of a situation—for example, having your current job—compared to what you would get if the current situation were no longer possible. To calculate employment rent—or in other words, the net cost of job loss—we need to weigh up all the benefits and costs of working compared with being unemployed and searching for another job. Even confining attention to the loss in wages, the cost is high. But how do we measure how high it is?

      Can we compare the economic situation of workers currently employed with the economic situation of unemployed people?