HARVARD UNIVERSITY DEPARTMENT OF ECONOMICS

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1 HARVARD UNIVERSITY DEPARTMENT OF ECONOMICS ECONOMICS 970 SPRING 2005 AN ECONOMIC STUDY OF THE FIRM Tue & Thu 7 8:30 PM Instructor: Location: Saravanan Kesavan skesavan@hbs.edu (617) Room: 116, Science Center In most undergraduate basic and intermediate economics courses, firms are a little more than a simple production function. In the outside world, of course, matters are much more complicated. A firm has individuals it must manage, and must interact with other firms or individuals to conduct its business. In addition, most of the early years in an undergraduate s economic studies are devoted to the price system. As the story goes, markets know exactly how much of each good and service to produce by simply exchanging price information. But, if the price system is so efficient, why do we have firms in the first place? Shouldn t we be able to contract all services freely from spot markets? The existence of firms in every industry, and the nature of employment seem to tell a different story. Clearly, there must be a cost of using the price mechanism. On the other hand, if firms do provide a role of coordination better than the price system, Why is not all production carried on by one big firm? 1 Even if the general decreasing-returns-toscale-in-technology story we often hear applies, one could see one giant firm organizing each activity at its point of most efficiency. There must be, in addition to decreasing returns to technology, decreasing returns to management. In this seminar, we take a top-down approach where we start with some of the seminal literature on the nature of the firm. Then we reduce the scope and look at certain economic issues that are relevant to the firm such as productivity, firm profitability etc. Finally, we dive down into the details by analyzing econometric models that are appropriate for measuring and studying firm characteristics such as scale economies, quality change, effect of advertising on sales etc. The goal of this seminar is to a) provide a broad overview of the firm (theoretical); b) study a few issues in detail (both theoretical and empirical) and c) enable students to do research (empirical). The mixture of papers covered is approximately half theoretical and half empirical. Most of the papers included are mathematically challenging, specially the theoretical ones. Students with background of level 2 and above in mathematics should be comfortable with the readings in this course. The primary mode of learning will be through discussion. There will be no formal lectures. Often, students will be asked to read part of the material, explain it and defend it to others who read competing views. Course Requirements Class Participation (30%) Attendance is mandatory. Class discussion is an essential component of this tutorial. Be prepared to discuss the assigned readings in class. Short Essays (30%) Each student must send me a one page report on the readings for that class due 10 AM on the morning of the class. For example, class 3 meets on February 17 th at 7 PM. Each student needs to send a one 1 Ronald Coase Page 1 of 6

2 page report on the readings for this class by 10 AM on 17 th. Note that you do not need to send me a report for the first class that meets on February 10 th. The report should not be a simple summary of each paper. Students need to express what they found intriguing (or not) with the papers. Bonus points to students who can contradict the author(s) USING VALID REASONING. The idea behind the report is to ensure that the students have read the paper and have spent some time thinking about it. It is critical that students develop an opinion about the papers before they enter the class in order to have a healthy discussion on the subject matter. Empirical Exercise (10%) We will obtain estimates of multifactor productivity growth. The empirical exercise will be due exactly two weeks after class 11, where we will discuss some background material relevant to this exercise. The approximate due date is in the first week of April. The report should approximately be 5 pages long. Term Paper (Including Prospectus) (30%) You will be required to submit a term paper of double-spaced-font-size-11 pages related to one of the topics addressed in this course. It is acceptable to expand on one of the topics covered in the short essays, but the analysis must be considerably deeper and richer. A prospectus of 3-5 pages and a preliminary bibliography is due on March 24. We will collectively discuss everyone s prospectuses in the last day of the class. The class discussion, together with the instructor s comments will provide (hopefully) useful feedback for the paper. The term paper will be due on Friday, May 13. Course Policies Attendance. Attendance is mandatory. Exceptions for personal of family emergencies will be granted on a case by case basis. Tardiness. Unless otherwise stated, papers are due no later than 7 PM of the assigned date. You can either me the assignment (preferred method), bring it to class, or drop it in my mail box. For each late day (without my specific approval), the assignment grade will lose 10 % of its value (therefore, it is of no use handing in something 10 days late). I consider anytime after 7 PM as one late day. Office hours. There are no official office hours. However, I will be happy to discuss course issues outside of the regularly scheduled class hours. Please contact me via if you need to set up an appointment. My office is located in T81C, Morgan Hall, HBS. Readings The readings for each class are detailed in this syllabus. Whenever feasible, the readings will be ed as pdf documents to the students. The required book for this course is Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary. Addison Wesley. Readings pertaining to the book will not be provided. So students should either purchase or borrow this book from library. Apart from the readings, the empirical exercise uses data provided in the diskette attached to the book. Writing Writing is a crucial part of the sophomore tutorial and of the Harvard Experience. Development of good writing skills is essential to your success as an economist, or in any other profession From the Economics 970 Tutorial Leader Handbook Papers must have a clear purpose, a question they are trying to answer. In addition to this, we are, in particular, interested in economic analysis and reasoning. Try to be clear in your arguments, and relate your ideas to the models in your bibliography. Please proofread your papers. Although clarity is more important than command of the English language, poorly revised grammar will lower your grade. Be familiar with the University s policies on plagiarism. It is perfectly acceptable to borrow ideas from others, as long as due credit is clearly stated. Class 1 Theories of the Firm: Foundations I R. H. Coase, The nature of the firm, Economica, 1937 Page 2 of 6

3 Arrow, Ch 2, and Ch 4, in The Limits of Organizations Oliver Williamson, The Vertical Integration of Production: Market Failure Considerations, American Economic Review, 1971 Class 2 Theories of the Firm: Foundations II O. Williamson, Transaction Cost Economics: The Governance of Contractual Relations, Journal of Law and Economics, 1979 Paul Joskow, Asset Specificity and the Structure of Vertical Integration, in The Nature of the Firm, Origins, Evolution and Development, by O Williamson and S G Winter, 1993 Oliver Hart. Firms, Contracts and Financial Structure. Chapter 2. Class 3 Theories of the Firm: Foundations III Michael Jensen, and William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics, 1976 A. Alchian and H Demsetz, Production, Information Costs and Economic Organization, American Economic Review, 1972 Harold Demsetz, The Theory of the firm Revisited, in The Nature of the Firm, Origins, Evolution and Development, by O Williamson and S G Winter, 1993 Class 4 Theories of the Firm: Foundations IV S. Ghoshal, P. Moran, Bad for Practice: A Critique of the Transaction Cost Theory, Academy of Management Review, 1996 Paul Milgrom and John Roberts, Economic Theories of the Firm, Past, Present and Future, Canadian Journal of Economics, 1988 Class 5 Theories of the Firm: Alternative Organizational Forms Miles and Snow, Organizations: New Concepts and New Forms, California Management Review, J. Podolny and K. Page, Network Forms of Organization, Annual Review of Sociology, M Aoki, Toward an Economic Model of the Japanese Firm, Journal of Economic Literature, Class 6 Theories of the Firm: What limits firm size? O. Williamson, The Limits of Firms: Incentive and Bureaucratic Features, in The Economic Institutions of Capitalism, B. Homlstrom, J Roberts, The Boundaries of the Firm Revisited, The Journal of Economic Perspectives, Class 7 Relationships with Suppliers and Vertical Integration B. Klein, Vertical Integration as Organizational Ownership, The Fisher Body-General Motors Relationship Revisited, Journal of Law, Economics, and Organization, 1988 B. Klein, R. Crawford and A. Alchian, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, Journal of Law and Economics, 1978 Casadesus-Masanell and Spulber, The Fable of Fisher Body, Journal of Law and Economics, 2000 Class 8 Incentives in Organizations I Roy, Quota Restrictions and Goldbricking in a Machine Shop, The American Journal of Sociology, 1952 R. Gibbons, Piece Rate Incentive Schemes, Journal of Labor Economics, 1987 Page 3 of 6

4 Gibbons, Incentives and Careers in Organizations, in Advances in Economic Theory and Econometrics Class 9 Incentives in Organizations II: Career Concerns and other issues Gibbons and Murphy, Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence Lazear and Rosen, Rank Order Tournaments as Optimum Labor Contracts, Journal of Political Economy, J. Chevalier and G. Ellison, Career Concerns and Mutual Fund Managers, The Quarterly Journal of Economics, 1999 Class 10 Incentives in Organizations III: CEO compensation Jensen and Murphy, Performance Pay and Top Management Incentives, The Journal of Political Economy, B. Hall and K. Murphy, Stock Options for Undiversified Executives, Journal of Accounting and Economics, 2002 Jensen and Ruback, The Market for Corporate Control, Journal of Financial Economics, 1983 Class 11 Empirical Exercise on multi-factor productivity Empirical Exercise Based on this. Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary Chapter 9 Morrison, C.J., and Berndt, E, Short-run labor productivity in a dynamic model, Journal of Econometrics, Vol. 16 (1981). Recommended: Kmenta, On Estimation of the CES Production Function, International Economic Review, Vol.8 (2), Class 12 Firm Profitability: Industry View Schmalensee, R, Do Markets Differ Much? The American Economic Review, Vol. 75 (3) June McGahan, Anita and Porter, M, How much Does Industry Matter Really?, Strategic Management Journal, Vol. 18, Caves, Gale and Porter, M.E., Interfirm Profitability Differences: Comment, The Quarterly Journal of Economics, Vol (91) Nov Class 13 Firm Profitability: More Views Cubbin, and Geroski, P, The Convergence of Profits in the Long Run: Inter-firm and Inter-Industry Comparisons, The Journal of Industrial Economics, Vol 35 (4), June Selling, T and Stickney, C, The Effects of Business Environment and Strategy on a Firm s Rate of Return on Assets, Financial Analysts Journal, Jan-Feb 1989, McGahan, A and Porter, M, The Persistence of Shocks to Profitability, The Review of Economics and Statistics, VOl 81(1), Feb Class 14 Firm Productivity Skinner, W The Productivity Paradox, Harvard Business Review, July-August Hayes, R and Clark, K, Why some factories are more productive than others, Harvard Business Review, Sept-Oct Brynjolfsson, E and Hitt, L, Computing Productivity: Firm-Level Evidence, The Review of Economics and Statistics, Vol. 85 (4), Nov Class 15 Firm Productivity (contd.) Brynjolfsson, E, Yu and Smith, M, Consumer Surplus in the consumer economy: Estimating the value of increased product variety at online booksellers, Management Science, Vol 49 (11), Nov Page 4 of 6

5 Hitt, L and Brynjolfsson, E, Productivity, business profitability, and consumer surplus: Three different measures of information technology, Vol 20 (2), June Class 16 The Operations View: Intra-Company Coordination Toyota Motor Co, HBS Case Karmakar, Getting Control of Just in Time, Harvard Business Review,1989. P. Milgrom and J. Roberts, The Economics of Modern Manufacturing Technology, Strategy and Organization, The American Economic Review, Recommended: E. Goldratt, The Goal Class 17 The Operations View: Inter-Company Coordination Barilla SPA, HBS Case H. Lee, v. Padmanabhan, S. Whang, The Bullwhip Effect, Management Science, 1997 Hamptonshire Express, HBS Case Class 18 Empirical Papers: Part I Analyzing determinants of wages Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary, Chapter 5 Griliches, Zvi and Mason, W, Education, Income and Ability, Journal of Political Economy, Vol: 80 (2), May- June Class 19 Empirical Papers: Part II Costs, Learning Curves and Scale Economies Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary, Chapter 3 Abernathy, W and Wayne, K, Limits of Learning Curve, Harvard Business Review, Sept/Oct Hirsch, W, Manufacturing Progress Functions, The Review of Economics and Statistics, Vol. 34 (2), May Class 20 Empirical Papers: Part III Measurement of Quality Change Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary, Chapter 4 Chow, G, Technological change and the demand for computers, American Economic Review, Vol 57 (5), Dec Class 21 Empirical Papers: Part IV Causality between advertising and sales Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary, Chapter 4 Bass, Frankt, Some case histories of Econometric Modeling in Marketing: What really happened, Interfaces, Vol 10 (1) Deb Ashley, Granger and Schmalensee, R, Advertising and aggregate consumption: An Analysis of Causality, Econometrica, Vol 48 (5), July Class 22 Empirical Papers: Part V Demand for Electricity Ernst R. Berndt The Practice of Econometrics: Classic and Contemporary, Chapter 7 Caves, D, Christensen, L and Herriges J, The Neoclassical model of consumer demand with identically priced commodities: An application to time-of-use electricity pricing, The RAND Journal of Economics, Vol 18 (4) Winter Page 5 of 6

6 Class 23 Wrap Up Course Summary Discussion of Students Paper Proposals. Page 6 of 6