Lecture 4
Devision of labor: specialization, coordinated in 2 different ways; either firm-wise or market-wise.
Economic power: in a firm there Is asymmetric information between levels in the hierarchy. In firms,
there is a power to say someone has to do something, in a market you cannot say someone else has
to buy something. However, managers of a firm cannot completely control their workers.
But in a market; contracts. Products’ ownerships are permanently transferred from seller – buyer.
Contracts in a firm; (labor) temporarily transfer authority over a person’s activities from employee –
manager/owner.
In a firm; separation of ownership and control -> conflict of interest.
As managers (and ordinary workers) don’t automatically benefit from profits thanks to their work,
there is a conflict of interest, since they will not do their best, it is of no importance to them. To avoid
this; link the salaries to the profits or share prices of the firm (percentages) or monitor a manager’s
performance.
Incomplete contract: a firm cannot know exactly what it will need the employee to do and some
aspects are difficult to measure (effort). In an incomplete contract, not every aspect of the exchange
that affects the interests of the parties is specified.
To avoid this; piece rate work is where the worker is paid per product they make (an incentive to
exert effort), but nowadays this is difficult to measure and employees often work in a team.
->large the employment rent -> large cost of job loss (raise wage -> trade-off between effort & wage)
Employment rent: net cost of job loss; a combination of benefits (wage income and social status) and
costs (travel cost and disutility from work).
Reservation option (wage): the value of the next best option.
Employment rent decreases as unemployment benefit is received (subsidies etc.) as the net value of
unemployment increases.
The Employment Game; a sequential, repeated game between employer and worker.
Payoffs; for the employer: its profit = worker’s output – wage
for the worker: net valuation of wage = wage – cost of effort-reservation option
The best response for a worker is the effort level that gives the highest net valuation of wage (for a
given wage level). -> The effort level will increase as the offered wage increases. Also the disutility of
effort increases as the level of effort increases -> the line of best response isn’t linear (but concave).
For the employer, the best response curve (of the worker) is the feasible frontier of wages/effort
combinations. The slope of the line is the MRT of wage into effort; ∆ effort / ∆ wage. This slope
flattens (decreases) as the wage increases -> diminishing marginal returns of effort.
Devision of labor: specialization, coordinated in 2 different ways; either firm-wise or market-wise.
Economic power: in a firm there Is asymmetric information between levels in the hierarchy. In firms,
there is a power to say someone has to do something, in a market you cannot say someone else has
to buy something. However, managers of a firm cannot completely control their workers.
But in a market; contracts. Products’ ownerships are permanently transferred from seller – buyer.
Contracts in a firm; (labor) temporarily transfer authority over a person’s activities from employee –
manager/owner.
In a firm; separation of ownership and control -> conflict of interest.
As managers (and ordinary workers) don’t automatically benefit from profits thanks to their work,
there is a conflict of interest, since they will not do their best, it is of no importance to them. To avoid
this; link the salaries to the profits or share prices of the firm (percentages) or monitor a manager’s
performance.
Incomplete contract: a firm cannot know exactly what it will need the employee to do and some
aspects are difficult to measure (effort). In an incomplete contract, not every aspect of the exchange
that affects the interests of the parties is specified.
To avoid this; piece rate work is where the worker is paid per product they make (an incentive to
exert effort), but nowadays this is difficult to measure and employees often work in a team.
->large the employment rent -> large cost of job loss (raise wage -> trade-off between effort & wage)
Employment rent: net cost of job loss; a combination of benefits (wage income and social status) and
costs (travel cost and disutility from work).
Reservation option (wage): the value of the next best option.
Employment rent decreases as unemployment benefit is received (subsidies etc.) as the net value of
unemployment increases.
The Employment Game; a sequential, repeated game between employer and worker.
Payoffs; for the employer: its profit = worker’s output – wage
for the worker: net valuation of wage = wage – cost of effort-reservation option
The best response for a worker is the effort level that gives the highest net valuation of wage (for a
given wage level). -> The effort level will increase as the offered wage increases. Also the disutility of
effort increases as the level of effort increases -> the line of best response isn’t linear (but concave).
For the employer, the best response curve (of the worker) is the feasible frontier of wages/effort
combinations. The slope of the line is the MRT of wage into effort; ∆ effort / ∆ wage. This slope
flattens (decreases) as the wage increases -> diminishing marginal returns of effort.
