UMKC Micro-Chapter 6: The Firm: Owners, Managers, and Employees

Outsourcing or Offshoring

The relocation of part of a firm's activities outside of the national boundaries in which it operates. It can take place within a multinational company or may involve outsourcing production to other firms.


Economic organization in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.

Division of Labour

The specialization of producers to carry out different tasks in the production process. Also known as: specialization.

Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways: firms and markets.

-Through firms, the components of goods are produced by different people in different departments of the firm, and assembled to produce the finished shirt or iPhone.
-Or components produced by groups of workers in different firms may be brought together t

The way that labour is coordinated within firms is different to coordination through markets:

-Firms represent a concentration of economic power:
This is placed in the hands of the owners and managers, who regularly issue directives with the expectation that their employees will carry them out. An 'order' in the firm is a command.
-Markets are cha

Asymmetric Information

Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.


A legal document or understanding that specifies a set of actions that parties to the contract must undertake.

Wage Labour

A system in which producers are paid for the time they work for their employers.

Relationship-Specific or Firm-Specific Assets

Something that a person owns or can do that has more value in the individual's current firm than in their next best alternative.

residual claimant

The person who receives the income left over from a firm or other project after the payment of all contractual costs (for example the cost of hiring workers and paying taxes).


A part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm's profit and to benefit when the firm's assets become more valuable. Also known as: common stock.

separation of ownership and control

The attribute of some firms by which managers are a separate group from the owners.


Benefiting from the contributions of others to some cooperative project without contributing oneself.

A firm's profits (before the payment of taxes) depend on three things:

-costs of acquiring the inputs necessary for the production process
-output (how much these inputs produce)
-sales revenues received from selling goods or services

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:

-When the firm writes a contract for the employment of a worker, it cannot know exactly what it will need the employee to do, because this will be determined by unforeseen future events.
-It would be impractical or too costly for the firm to observe exact

incomplete contract or contractual incompleteness

A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

piece-rate work

A type of employment in which the worker is paid a fixed amount for each unit of the product made.

Why do most of today's firms not use this simple method to induce high effort from their employees?

-It is very difficult to measure the amount of output an employee is producing in modern knowledge- and service-based economies (think about an office worker, or someone providing home care for an elderly person).
-Employees rarely work alone, so measurin

Employment rent

The economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.

Employment rents can benefit owners and managers in two ways:

-The employee is more likely to stay with the firm:
If she were to quit the job, the firm would need to pay to recruit and train someone else.
-They can threaten to fire the worker:
Owners and managers exert power over employees because the employee has s

There are some costs of working, such as:

-The disutility of work:
Employees must spend time doing things they would prefer not to do.
-The cost of traveling to work every day.

But there are many benefits, which would be lost if you lost your job:

-Wage income:
This may be partially offset by an unemployment benefit or, in poorer countries, by the possibility of lower-paying self-employment or work on the family farm.
-Firm-specific assets:
These include workplace friends, and perhaps the proximity

natural experiment

An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, we


A numerical indicator of the value that one places on an outcome, such that higher valued outcomes will be chosen over lower valued ones when both are feasible.

net utility per hour=

wage ? disutility of effort per hour

(1) total employment rent=

employment rent per hour�expected lost hours of work
=$10 per hour�1,540 hours

unemployment benefit

A government transfer received by an unemployed person. Also known as: unemployment insurance

reservation wage

What an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.

employment rent per hour=

wage?unemployment benefit?disutility of effort

total employment rent=

employment rent per hour � expected hours of lost work time
=$4 per hour � 1,540 hours

Disutility of labor

Economists' term to describe the fact that people prefer leisure to labor. People only engage in labor because of its indirect rewards.


Ability or capacity of a good or service to be useful and give satisfaction to someone.

Nash equilibrium

A set of strategies, one for each player in the game, such that each player's strategy is a best response to the strategies chosen by everyone else.

best response curve, or best response function

worker's best response function (to wage)- The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.

efficiency wages

The payment an employer makes that is higher than an employee's reservation wage, so as to motivate the employee to provide more effort on the job than he or she would otherwise choose to make. See also: labour discipline model, employment rent.

labour discipline model

A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.

unemployment, involuntary

The state of being out of work, but preferring to have a job at the wages and working conditions that otherwise identical employed workers have. See also: unemployment.

worker-owned cooperative or cooperative firm

A firm that is mostly or entirely owned by its workers, who hire and fire the managers.

principal-agent relationship

This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: in

hidden actions problem

This occurs when some action taken by one party to an exchange is not known or cannot be verified by the other. For example, the employer cannot know (or cannot verify) how hard the worker she has employed is actually working. Also known as: moral hazard.

Q 6.1: Which of the following statements is true?
a. A labour contract transfers ownership of the employee from the employee to the employer.
b.The office where the employee works is a relation-specific asset, because the employee cannot use it after leav

c.In a labour contract, one side of the contract has the power to issue orders to the other side, but this power is absent from a sale contract.
Reason: A labour contract gives the employer the authority to direct the activities of the employee,

Q6.2: Which of the following statements about the separation of ownership and control is true?
a. When the ownership and control of a firm is separated, the managers become the residual claimants.
b. Managers always work to maximize the firm's profit.

c. One way to address the problem associated with the separation of ownership and control is to pay the managers a salary that depends on the performance of the firm's share price.
Reason: Such performance-related pay is a common method of incentivizing m

Q 6.3: Which of the following are reasons why employment contracts are incomplete?
a. The firm cannot contract an employee not to leave.
b. The firm cannot specify every eventuality in a contract.
c. The firm is unable to observe exactly how an employee i

a. The firm cannot contract an employee not to leave.
b. The firm cannot specify every eventuality in a contract.
c. The firm is unable to observe exactly how an employee is fulfilling the contract.
a. It may be costly for the firm if the employee

Q6.4: In which of the following employment situations would the employment rent be high, ceteris paribus?
a. In a job that provides many benefits, such as housing and medical insurance.
b. In an economic boom, when the ratio of job-seekers to vacancies is

a. In a job that provides many benefits, such as housing and medical insurance.
d. When the worker is paid a high salary because the firm's customers know and trust her.
a. If the employee loses the job, all these benefits would be lost, so the e

Q6.5: Maria earns $12 per hour in her current job and works 35 hours a week. Her disutility of effort is equivalent to a cost of $2 per hour of work. If she loses her job, she will receive unemployment benefit equivalent to $6 per hour. Additionally, bein

d. Maria's employment rent if she can only get a job at a lower wage rate after 44 weeks of being unemployed is more than $7,700.
Reason: If she could get a job at the same wage after 44 weeks, Maria's employment rent = $5 (employment rent per hour) � 35

Q6.6: Figure 6.4 depicted Maria's best response curve when the expected duration of unemployment was 44 weeks. Which of the following statements is correct?
a. If the expected unemployment duration increased to 50 weeks, Maria's best response to a wage of

a. If the expected unemployment duration increased to 50 weeks, Maria's best response to a wage of $12 would be an effort level above 0.5.
c. Over the range of wages shown in the figure, Maria would never exert the maximum possible effort per hour.

Q6.7: Figure 6.6 depicts the efficiency wage equilibrium of a worker and a firm. According to this figure:
a. Along the isocost line tangent to the best response curve, doubling of the per-hour effort from 0.45 to 0.90 would lead to an increased profit fo

b. The slope of each isocost line is the number of units of effort per dollar.
Reason: Isocost lines have a constant ratio of effort to wage, e/w. Since e is on the vertical axis, and w is on the horizontal axis, the slope is e/w, which is the number of u

Q6.8: Which of the following statements are true?
a. If unemployment benefits are increased, the minimum cost of a unit of effort for the employer will rise.
b. If the wage doesn't change, employees will work harder in periods of high unemployment.
c. If

a. If unemployment benefits are increased, the minimum cost of a unit of effort for the employer will rise.
b. If the wage doesn't change, employees will work harder in periods of high unemployment.
a. An increase in unemployment benefits shifts