CHAPTER 4
Spontaneous Order and the Firm
CHAPTER SUMMARY AND TEACHING OBJECTIVES
Business firms exist because of imperfect information. Complete contracts covering all contingencies
can never be written. Yet, decisions must be made. It is in this void that we see the firm. If, in some
sense, the firm replaces the market then there needs to be an understanding of how the firm should
operate to be efficient. This centers on the issue of corporate governance and how it addresses the
inherent principal-agent problem in the corporate form of business. Property rights are still needed even
in this setting.
IMPORTANT TERMS
residual income income left after all costs have been paid
complete contract contracts that account for every contingency
incomplete contracts situations were all contingencies are not covered by a contract
vertically integrated when a firm carries out more than one step in the vertical chain
boundaries the limits to the size of a firm
supply chain the entire vertical process from raw materials to the final consumer good
TOPICS AND TEACHING SUGGESTIONS
1. Hayek and Spontaneous Order
Firms exist because complete contracts cannot be written to cover all possible contingencies.
2. The Analogy between Markets and Firms
3. Property Rights in the Firm
Who owns what in the firm? The firm owns the right to use resources. The relationship between
ANSWERS TO EXERCISES
1. Why do firms exist? Why is there not just one large firm?
2. Would there be a reason for firms to exist in a world where there were complete contracts?
Why or why not?
3. If investors are reluctant to invest in companies whose CEOs have unsavory reputations or
companies that despoil the environment, then we might expect (explain)
a. the value of a company to reflect the reputation of the CEO.
4. If investors are reluctant to invest in companies whose CEOs have unsavory reputations or
companies that despoil the environment, but information about CEOs and about activities
with regard to the environment are difficult for a typical investor to obtain, then we might
expect (explain)
5. Are there private property rights within a firm? Who owns what? What is not owned? Can
`trade and exchange occur within the firm without the existence of private property rights?
6. What are the “boundaries” of a firm? What determines the extent of vertical boundaries –
vertical integration? What determine the extent of horizontal integration – scope? Use a cost
benefit analysis to describe the optimal boundaries of a firm.
7. What is the purpose of a revolution? What forms do revolutions take – in countries, in firms?
8. Why did the evolution of large firms lead to a principal agent problem? How can the principal
agent problem between owners and managers be minimized?
9. What is the purpose of corporate governance?
10. If corporate governance is lax, then how might the interests of managers and owners be made
to coincide.
11. Confiscation of private property in nations occurs because of faulty governance. What does
faulty governance mean for a firm?
12. What is the role of the Board of Directors? Should the Board’s interests be aligned with
managers or owners? Explain.
13. In 2010, an explosion on an oil rig in the Gulf of Mexico led to the largest environmental
catastrophe in the United States. Is it possible that BP’s governance was at fault? Why or
why not?
14. Explain how a focus on core competency could be compatible with an expanding vertical
boundary. With an expanding horizontal boundary.
A core competency identifies the central mission of a firm – what it does best. By identifying
15. What is meant by “supply chain”? Explain when a firm should bring its supply chain in–
house. Explain when a firm should leave its supply chain external.
The supply chain is the entire vertical process from raw materials to the final consumer good.
The decision of whether or not to expand the supply chain should follow the fundamental rule
16. In Chapter 1 it was noted that economics examines issues “at the margin.” Explain how this
would apply to the decision to make or buy.