Incentives, cooperation and the nature of the firm (2)
The firm can reduce many of the transaction costs associated with contracting by using team production. Team production, however, comes with another set of problems. Team members – the employees working for the firm. – must be monitored and given incentives to avoid shirking, or working at less than the expected rate of productivity. Taking long work breaks, paying more attention to their own convenience than to work results, and wasting time when diligence is called for are examples of shirking. A worker will shirk more when the costs of doing so are shifted to other team members, including the owners of the firm. Hired managers, even including those at the top, must be monitored and given incentives to avoid shirking.
Imperfect monitoring and imperfect incentives are a problem with team production. It is part of a larger class of what economists call principal-agent problems. A person taking a car to an auto mechanic confronts this problem. The mechanic wants to get the job done quickly and make as much money on it as possible. The car owner wants to get the job done quickly also, but wants the problem fixed in a lasting way, at the lowest possible cost. Because the mechanic typically knows far more about the job than the customer, it is hard for the customer to monitor the mechanic’s work. There is a possibility, therefore, that the mechanic may charge a large amount for a “quick fix” that will not last.
The owner of a firm is in a similar situation. It is often difficult to monitor the performance of individual employees and motivate them in a way that will encourage high productivity. Nonetheless, the ability of the firm to use resources effectively and succeed in a competitive market depends crucially upon resolving these problems. To keep costs low and the value of output high, a firm must discover and use an incentive structure that motivates managers and workers, and discourage5 shirking. The problem extends all the way to the top.
Even top-level executives hired to manage a firm do not have the same objectives as owners – who care mainly about profit maximization – unless, of course, the managers are the owners. So the judgments of executives, too, are influenced by what is in their personal best interests. They want perks, personal job security, and other benefits that may not be consistent with profit maximization for the firm. The problem becomes more serious as firms grow larger and acquire more managers and employees. Ultimately, it is the job of the owners, as residual claimants, to develop an incentive structure to minimize the principal-agent problem. For the owner, the saying “the buck stops here” always applies.
Incentives, cooperation and the nature of the firm (1)
In capitalist countries, most firms are privately owned. Owners risk their wealth on the success of the business. If the firm is successful and earns profits, these financial gains go to the owners. Conversely, if the firm suffers losses, the owners must bear the consequences. Because the owners receive what remains after the revenue of the firm is used to pay the contractual costs, they are called residual amiantus.
In a market economy, the property right of owners to the residual income of the firm plays a very important role: it provides owners with a strong incentive to organize and structure their business in a manner that will keep the cost of producing output low (relative to its value). The wealth of these residual claimants is directly influenced by the success or failure of the firm. Thus, they have both the authority and a strong incentive to see that resources under their direction are used efficiently and directed toward production do goods that are valued more highly than their costs.
In principle, all production could be accomplished solely through contracting. For example, a builder might have a house built by contracting with one person to pour the concrete, another to construct the wooden part of the house, a third to install the roofing, a fourth to do the electrical wiring, and so on. No employees would have to be involved in such a project. More commonly though, goods and services are produced with some combination of contracting and the use of team production by employees of a firm.
Why do firms use team production? If contracting alone is used to produce some- thing, the producer must, for each project, (1) determine what needs to be produced and how, given the circumstances, current technology, and prices, (2) search out reliable suppliers, and (3) negotiate and enforce the contracts. The entrepreneur who wants to produce by this method must have specialized knowledge in a variety of areas and must devote a great deal of time and effort to the planning and contracting processes. Not many people have the expertise or the time to perform all these tasks by themselves except on a small scale. Team production for certain tasks can be more practical and less costly.
Accordingly, a builder with multiple projects is likely to hire knowledgeable, experienced workers to plan the construction process, purchase materials, and build the structures. The builder will then contract with others to obtain materials and more specialized labor services.