(Micro) Firm

Prerequisite: Choice of contracts
Private Property Right - risk dispersion (1st) HKAL Economics

- Why, How, Apply - transaction cost (2nd) Chapter 15 The Nature of Firms
恆商生編寫經濟科精要筆記 (參考 HSSC, Daniel Yu, Fred

Chan Economics)
Email: noteseller70@yahoo.com.hk
Reference:
http://hk.f2.page.auctions.yahoo.com/hk/auction/b16328297
相信大家面對經濟科時，會有以下難題
1. 本本書同筆記都有不同的定義，要記都唔知記邊個!
2. 張五常的理論有很多，但往往都不知要學邊個!
3. 知道要溫張五常的著作，但其理論卻東一份西一份，又有經濟解釋，
又有賣桔者言，更不要說在早期有蘋果日報的專欄文章!
4. 答 MICRO SECTION B 時，不知什麼是給分位，什麼是冇分位!
5. 學 MACRO 時，知道哂教科書的理論，但看看阮志華(出卷人)的解釋，
卻不知從何入手!
對於以上難題，在恒商校內試和公開試奪 A 的我，在 ALEVEL 時早有準

備，製造一連串筆記解決以上難題! 現公開分享!!
PACKAGE:
1. Micro topic (18 topics) analysis - over 150 pages
2. Macro section (8 sections) analysis - over 80 pages
3. Daniel Yu Expanded version (in doc format)
4. HSSC powerpoint notes (the whole syllabus)
5. MOCK collection (HSSC, KTC, CLIFF YEUNG)
歡迎問價和索取 SAMPLES!!
-1–
/opt/scribd/conversion/tmp/scratch6738/52365790.doc
Points to note:
1. A firm’s
Economic function Reduce transaction costs
(Why)
Organisational The differential criteria; separation
characteristics (How) between product and factor market; as a
middleman.
2. An invisible hand (markets) refers to (1) the allocation of scarce

resources (WHAT), (2) methods of production (HOW) and (3)
distribution of income (FOR WHOM) by the price mechanism.
3. A visible hand refers to the allocation of scarce resources methods

of production and distribution of income are directed by an director
(an entrepreneur in a firm) or a planner (government officials in a
planned economy.
4. Resource allocation under zero transaction cost is guided by an

invisible hand. The what, how and for whom to produce questions
are answered by a system of market prices. (Appendix 1)
5. Under zero transaction costs, input owners (i.e. factor owners) sell
his product directly to customers.
6. In classical theory, product market is guided by invisible hand (i.e.

demand & supply); while, factor market is guided by visible hand
(i.e. factor owners sell their services to an entrepreneur.)
7. Factors of production are transacted in both firms and markets. (∵

the use of firm is a marginal substitution.)
8. The presence of transaction costs is an essential prelude to the

existence of firms and the separation of factor market from product
market.
9. The emergence of firms is to reduce transaction costs.
-2–
10. Under zero transaction costs, the following reasons to explain the
emergence of firms are futile.
(i) Specialisation and coordination
(ii) The shirking problem
(i.e. entrepreneur helps monitor workers, ∵ if not,
entrepreneur earn less income, as a residual claimant)
(iii) Risk and uncertainty
(i.e. an entrepreneur bears the risks and thus is
empowered to direct others factors of production who dare
not run risks. Entrepreneurs will try to make correct
decision due to ‘profit’ incentive)
11. The replacement of the market by the firm is to reduce the following
transaction costs. i.e. using the price mechanism to coordinate
production process will inevitably involve huge transaction costs,
and the emergence of firms tends to reduce these costs.
(i) Information of - A specialised firm has better
knowing products knowledge about products.
(physical and value - Less costly to negotiate the
sense)
payments to resource owners.
(ii) Measurement cost of - Quote one price
components’ value - Customers can simply assess
(i.e. customers have the value of the final product as
to assess the values a whole at lower TC (MUV Vs
of all the P)
components.)
(iii) Large number of - Firms coordinate with all
transactions required resource owners
(∵specialisation, ∴ less costly to
negotiate the price with resource
owners)
- Quote one price and thus one
transaction
(iv) The problem of - Payment for input owners on a
separating take-it-or-leave-it basis by
contributions measuring a proxy.
- Instead of referring their MRP
12. The product market will be replaced by the firm, or the product
market will be superseded by the factor market. (Coase’s view)
-3–
13. The transaction costs of using firms are (1) supervising workers’
performance and (2) co-ordinating factors of production.
14. Firm will be chosen if the transaction costs involved are less than
that of using the price mechanism. The choice between market and
firms is a marginal decision.
Points for credit
15. The transaction costs of using a firm will be raised due to
diminishing returns of management. Firms replacing market as a
marginal substitution. A firm ceases to grow when the costs of
organising an extra transaction within a firm (visible hand) equals
the costs of carrying out the same transaction by means of price
mechanism (invisible hand).
16. However, the dual nature of the piece-rate contract renders one
impossible to speak of a separation between the product market and
the factor market; nor to speak of the supper session of the market
by the firm. (∵ input owners work under a firm’s direction, but are
paid with reference to the price of its products.)
17. ****************************************************************************
Cheung argues that without knowing the contract details, it is
sometimes not easy to tell whether a firm exists or not from real
world observation.
(consider the shoe-shine boy case, pay for its final product (no firm)
or labour service (firm exists ∵labour service under the command of
the ‘consumer’?)
18. Given this difficulty, it is hard to say whether production activities are
coordinated by the market or the firm, and whether a product or a
factor market exists. (argue only for either one; not both.)
19. Under one condition can we argue that a firm and a market exist at
the same time. If there is a central agent or organisation which
employs the boy by paying a proxy and orders the boy to shine the
customers’ shoes (factor market). On the other hand, the central
-4–
agent, sells the service of shinning shoes to customers and charge

$10 for each pair of shoes shines (product market). Then, we say
that the factor and product market coexist.
20. Since any kinds of transactions involve contract, the choice of

organisational arrangement is actually the choice of contractual
arrangement.
21. One type of contract supersedes another type of contact.
22. The existence of contracts does not imply the existence of firms.
(consider product market.)
23. The choice of contracts was under constrained maximisation.

Therefore, we should never explain it is the flaws of the contracts’
nature attributable to losing money. (See Q10a of rent dissipation)
24. The choice of contracts should be beneficial and acceptable to both

parties. All the risks should not be borne by either the seller or the
buyer. (e.g. If only fixed rentals contract is used, the risk involved is
totally borne by the stores only. The stores may not be willing to
enter such contracts with high amount if fixed rentals charged.)
25. A firm is a way of organising production activities under contractual

arrangements without using market prices for every contribution
produced.
26. Cheung states that a firm can be as small as a contractual

relationship between two input owners or as big as the whole
economy if the chain of contacts is allowed to spread. In this sense,
the firm size becomes indeterminate and unimportant. What really
counts are the various ways of organising economic activities under
different transaction costs.
27. If there were no transaction costs,

Ans 1: No firms are required. (Appendix 4)
Ans 2: The choice of contracts is indeterminate since all of them
leads to identical resource allocation and income
-5–
distribution (∵ payments according to MRP).
28. A communist state is a big firm with central agent in charge of

resource allocation without reference to market signals.
29. TC of operating an organisation are necessarily higher in a

communist state than in a free enterprise state, due to the lack of
option of not joining and of competition both to recruit members
among organisations and to induce members to perform well.
30. If price mechanism is practised but not central decision, decisions

made are more responsive to the actual and rapidly changing needs
of people. For instance, facilities in greater demand will bring more
revenue and hence more quickly constructed. Or, the quality and
maintenance of the facilities depends on the potential incomes
earned from those facitlities.
31. There are two main criteria for the choice of contracts,
Risk dispersion Transaction costs
- measuring cost in inputs contributions
- measuring cost in output quality
- monitoring cost in input owners
- negotiating the share rate
- separating contribution
32. Work incentive is higher in fixed-rent contract than in share contract.
33. Bonus scheme implies lower unemployment rate.

- (auto. adjustment in wage, risk dispersion)
- (MP↑, MRP↑, Dlabour↑)
Appendix 1
-6–
The what, how and for whom to produce questions are answered by a system of
market prices.
♦ A shoe-shine boy who sells his product (i.e. shine) to customers on the street.
♦ He negotiates the price with customers (i.e. searching consumer’s MUV), and
then determines whether to shine for them (i.e. MC-MB(P) analysis) .
♦ The decisions to produce and to exchange by are entirely directed by the price,
and his income is determined by his contribution MRP (i.e. the exchange value
of the shines he made.)
♦ He, the input owner, receives market price as revenue.
Appendix 2
The differential criteria between a firm and a market
1. What are transacted? 5. How to answer what and how to
produce questions?
2. Type of market 6. How are the input owners paid?
3. Type of coordination among 7. Source of transaction costs
input owners
4. Type of contracts
Appendix 3
Consider middleman who buy a good from a producer and resells it to customer. Does
this contractual relationship between the producer and the middleman constitute a
firm?
♦ Define market and firm.
♦ State the organisational characteristics.
♦ Uncertain. It depends on which contract they involve.
♦ If the middleman in the question forms a product market with the producer,
♦ i.e. the middleman purchases the output produced from the producer at a
market price,
♦ the producer makes his production decision by responding to a price signal,
♦ and the producer receives payment according to their MRP, the production
activities will be coordinated by the invisible hand or market coordination,
♦ and that contractual relationship does not constitute a firm.
♦ However, if the middleman in the question forms a factor contract with the
producer,
♦ i.e. the middleman purchases the factor service from the producer,
♦ the producer makes his production decision by following the commands, orders
-7–
and directives of the middleman,

♦ and the producer receives payment at a proxy,
♦ then production activities will be coordinated by the visible hand or managerial
coordination, and that contractual relationship constitutes a firm.
Appendix 4
No firms are required in the absence of transaction costs.
♦ If transaction costs were truly zero, the preferences and comparative
advantages of all individuals would be perfectly known.
♦ A moderator would be able to assign people to their proper jobs, collect their
outputs, and distribute their outputs according to the known marginal
productivities and preferences without costs.
♦ There would no market and no market prices, but just a central agent whose
services were free of charge.
♦ No contracts or transaction with factors owners are needed.
♦ No firm exists.
Remark:
♦ A moderator is needed due to the existence of scarcity.
♦ No competition arises due to the ‘moderator’.
Appendix 5
Royalty rates are different among book writers; piece rates are different among
newspaper writers. For which of these payment methods would there be a larger
difference in the rates among writers.
- Difference is for reward and punishment for input owners.
Share contract Piece rates
Even if similar rates, If similar rates
- Good writers can still be rewarded since - Good writers cannot be
royalty is dependent on the sales volume. rewarded.
Appendix 6 (1991 C9, PP pg. 22)

In Hong Kong, taxi drivers typically rent taxis from taxi owners. In the 1960s, the taxi
rental arrangements were routinely on a share basis; for example, the taxi owner took
-8–
55 percent of the daily gross income while the drive took the remaining 45 percent.
However, since the mid-1970s until the present day, taxi rental has typically been on a
fixed-rent basis, i.e., the driver pays the owner a fixed sum of rent per day, and the
driver keeps the difference between the gross income and the fixed rent.
Under the earlier share-rent arrangement, the taxi owner paid for the cost of fuel;
under the present fixed-rent arrangement, the driver pays for the cost of fuel. In either
case, maintenance expenses are paid by the taxi owner.
(a) Why was the fuel cost paid by the owner under the share-rent arrangement, but it
is now paid by the leasing driver under the fixed-rent arrangement? (Hint: the taxi
driver would often have to drive around in an empty taxi looking for customers.)
(b) The cost of fuel rose sharply after 1973. Could this explain the change in taxi
rentals from a share-rent basis to a fixed-rent basis? Explain.
(c) Why are maintenance expenses paid by the taxi owners and by the leasing
drivers?
Appendix 7
In China, fees are almost routinely charged for facilities, such as highways, tourist
attractions, public parks, and even public toilets, subject to public usage. Such a fee-
charging practice is seldom used in the United States, where these public facilities are
well-maintained and provided to the public free of charge by the government.
(a) Would you expect such public facilities to be constructed/ provided more quickly
or more slowly in China than in the United States?
The US China
- Decision depends on the government - Decision depends on the market due
due to funding to fee charging
- Not according to the market - Facilities with greater demand, more
- Less responsive to the actual needs quickly constructed.
of the pubic - More responsive to the actual needs
(b) Would you expect the quality and maintenance of these facilities, say public parks,
to vary more greatly in China than in the United States?
The US China
- ∵ Decisions made by the govt. - ∵ Decisions made by the market
-9–
- Good maintenance does not bring - Good maintenance brings higher

higher income. income
- Maintenance would be more - Facilities with greater demand;
standardised maintained in good quality, vice
versa
- Varies more.
(c) Would you expect there to be more or less tourist guides serving tourist attractions
in China than in the United States? (14 marks)
- As the services of tourist guides are economic goods with positive construction
costs,
The US China
- Fee not collected in the facilities - Fee collected in the facilities
- Does not generate income or revenue - Does generate income or revenue
- No incentive to provide since costs - Incentive to provide since costs are
are never covered covered and sometimes plus a IRR
MC reminder
1. A firm exists when
A. teachers’ salaries are paid by the month in a private school.

B. a barber cuts hair of customers in a street corner.
C. Mrs. Chan employers a private tutor for her daughter and pays for the
tutor’s service.
D. All of the above.
A is correct due to proxy payment.

B and C are indeterminate since we do not know the contract
details.
2. In a certain garment factory, workers are paid by piece rates while the
foreman is paid a salary. This is because
A. for different performances, there are different costs associated

with monitoring inputs and outputs.
- 10 –
B. garment workers have a greater tendency to shirk working than workers

in other industries.
C. a higher-ranking post is typically paid by time rates.
B is wrong. Reduction in transaction cost is the priority of contractual

arrangement.
3. Taxi owners seldom hire taxi drivers on an hourly basis because
A. it is costly to monitor the drivers’ services to the passengers.

B. it is costly to verify whether the driver is working.
C. maintenance of the taxi is expensive.
A is wrong. The income earned by taxi drivers is based on the distance, but
not the quality.
4. If transaction costs are zero,
A. there will be no division of labour.

B. there will not be any consumption and production activities.
C. the choice of contractual arrangements will be indeterminate.
D. there is no risk.
D is wrong. Consider the case of a one-man economy.
- 11 –

(Micro) Firm

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Prerequisite: Choice of contracts

Private Property Right - risk dispersion (1st) HKAL Economics

恆商生編寫 經濟科精要筆記 (參考 HSSC, Daniel Yu, Fred

4. 答 MICRO SECTION B 時，不知什麼是給分位，什麼是冇分位!

對於以上難題，在恒商校內試和公開試奪 A 的我，在 ALEVEL 時早有準

2. An invisible hand (markets) refers to (1) the allocation of scarce

3. A visible hand refers to the allocation of scarce resources methods

4. Resource allocation under zero transaction cost is guided by an

6. In classical theory, product market is guided by invisible hand (i.e.

7. Factors of production are transacted in both firms and markets. (∵

8. The presence of transaction costs is an essential prelude to the

9. The emergence of firms is to reduce transaction costs.

agent, sells the service of shinning shoes to customers and charge

20. Since any kinds of transactions involve contract, the choice of

21. One type of contract supersedes another type of contact.

23. The choice of contracts was under constrained maximisation.

24. The choice of contracts should be beneficial and acceptable to both

25. A firm is a way of organising production activities under contractual

26. Cheung states that a firm can be as small as a contractual

27. If there were no transaction costs,

distribution (∵ payments according to MRP).

28. A communist state is a big firm with central agent in charge of

29. TC of operating an organisation are necessarily higher in a

30. If price mechanism is practised but not central decision, decisions

32. Work incentive is higher in fixed-rent contract than in share contract.

33. Bonus scheme implies lower unemployment rate.

and directives of the middleman,

Appendix 6 (1991 C9, PP pg. 22)

- Good maintenance does not bring - Good maintenance brings higher

A. teachers’ salaries are paid by the month in a private school.

A is correct due to proxy payment.

A. for different performances, there are different costs associated

B. garment workers have a greater tendency to shirk working than workers

B is wrong. Reduction in transaction cost is the priority of contractual

3. Taxi owners seldom hire taxi drivers on an hourly basis because

A. it is costly to monitor the drivers’ services to the passengers.

4. If transaction costs are zero,

A. there will be no division of labour.

D is wrong. Consider the case of a one-man economy.

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恆商生編寫經濟科精要筆記 (參考 HSSC, Daniel Yu, Fred