Unit 6 The firm and its employees

6.2 The structure of the firm: Owners, managers, and workers

Within firms, work is coordinated by owners and managers, who determine the tasks to be performed, employ workers to carry them out, and direct their activities. The managers of Walmart, the world’s largest retailer, direct the activities of 2.1 million employees, more people than in any army in world history before the nineteenth century. Walmart is exceptionally large, but—like many firms—it brings together a large group of people and coordinates their work to make profits.

Firms do not form spontaneously like flash mobs and then disappear. They are organizations with a decision-making process and ways of imposing decisions on the people in them.

Figure 6.1 shows a simplified picture of the firm’s actors and decision-making structure.

This diagram shows the relationship between the Board of Directors (owners), managers, and workers in a firm. Managers implement the long-term strategies decided by the Board of Directors, by assigning tasks to workers. Each manager is in charge of a number of workers. Workers often know things that managers do not, and managers know things that owners do not.
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Figure 6.1 The firm’s actors and its decision-making and information structures.

Owners decide long-term strategies: This diagram shows the relationship between the Board of Directors (owners), managers, and workers in a firm. Managers implement the long-term strategies decided by the Board of Directors.
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Owners decide long-term strategies

The owners, through their board of directors, decide the firm’s long-term strategies: how, what, and where to produce. They direct the manager(s) to implement these decisions.

Managers assign workers: This diagram shows the relationship between the Board of Directors (owners), managers, and workers in a firm. Managers implement the long-term strategies decided by the Board of Directors, by assigning tasks to workers. Each manager is in charge of a number of workers.
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Managers assign workers

Each manager assigns workers to the tasks required for these decisions to be implemented, and attempts to ensure that the assignments are carried out.

Flows of information: This diagram shows the relationship between the Board of Directors (owners), managers, and workers in a firm. Managers implement the long-term strategies decided by the Board of Directors, by assigning tasks to workers. Each manager is in charge of a number of workers. Workers often know things that managers do not, and managers know things that owners do not.
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Flows of information

The upward green arrows represent flows of information. They are dashed lines because workers often know things that managers do not, and managers know things that owners do not.

asymmetric information, asymmetry of 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.

The dashed green arrows represent a problem of asymmetric information between levels in the hierarchy (owners and managers, managers and workers). Since owners or managers do not always know what their subordinates know or do, not all of their directions or commands (grey downward arrows) are necessarily carried out.

Comparing interactions in firms and markets

Interactions within firms are different from interactions in markets:

  • In markets with many firms competing for customers, power is decentralized. Purchases and sales result from buyers’ and sellers’ independent decisions. An ‘order’ in a market is a request for a purchase that can be rejected if the seller pleases.
  • In firms, power is concentrated in the hands of the owners and managers, who issue directives and expect employees to carry them out. An ‘order’ in the firm is a command.

For example, a bakery cannot text its customers to tell them to ‘Show up at 8 a.m. and purchase two cakes for €1 each’. It could tempt them with a special offer, but it cannot require them to show up. When you buy or sell something, it is generally voluntary. You respond to prices, not commands.

But the bakery can tell its employees to show up and follow the orders of the manager. Firms have decision-making structures in which some people have power over others. Ronald Coase, the economist who founded the study of the firm as a stage, wrote:

If a workman moves from department Y to department X, he does not go because of a change in relative prices but because he is ordered to do so … the distinguishing mark of the firm is the suppression of the price mechanism. (‘The Nature of the Firm’, 1937) 1

Coase likened the firm in a capitalist economy to a miniature, privately owned, centrally planned economy. Its top-down decision-making structure resembles the centralized direction of production in entire economies that took place in many Communist countries (and in the US and the UK during the Second World War).2

When economists agree Coase and Marx on the firm and its employees

The writer, George Bernard Shaw (1856–1950), joked that ‘if all economists were laid end to end, they would not reach a conclusion.’

This is funny, but not entirely true.

Strikingly, two economists from different centuries and political orientations came up with similar ways of understanding the firm and its employees.

In the nineteenth century, Marx contrasted the way buyers and sellers interact in a market, voluntarily engaging in trade, with the firm’s organization as a top-down structure in which employers issue orders and workers follow them. He called markets ‘a very Eden of the innate rights of man’, but described the owners of firms as ‘exploit[ing] labour … to the greatest possible extent’.

When Ronald Coase died in 2013, he was described by Forbes magazine as ‘the greatest of the many great University of Chicago economists’. The motto of Forbes is ‘The capitalist tool’, and the University of Chicago has a reputation as the centre of conservative economic thinking.

Yet, like Marx, Coase stressed the central role of authority in the firm’s contractual relations:

Note the character of the contract into which an [employee] enters that is employed within a firm … for certain remuneration [the employee] agrees to obey the directions of the entrepreneur. (‘The Nature of the Firm’, 1937)

Coase sought to understand why firms exist at all, quoting his contemporary D. H. Robertson’s description of them as ‘islands of conscious power in this ocean of unconscious cooperation’.

Both based their thinking on careful empirical observation, and they arrived at a similar understanding of the hierarchy of the firm. But they disagreed on the consequences of what they observed: Coase thought that the hierarchy of the firm was a cost-reducing way to do business. Marx thought that the coercive authority of the boss over the worker limited the employee’s freedom. Despite their disagreements, Coase and Marx advanced economics with a common idea.

Question 6.2 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

  • Karl Marx and Ronald Coase came up with similar ways of understanding the firm and its employees.
  • The defining characteristic of markets, according to Marx, is that one party demonstrates authority over the other party.
  • Karl Marx emphasized the benefits of the authority structure that operates within firms.
  • Ronald Coase emphasized the benefits of the authority structure that operates within firms.
  • Both Karl Marx and Ronald Coase came up with a similar understanding of the hierarchy of the firm, based on careful empirical observation.
  • Marx discussed how market participants interact voluntarily. In contrast to this, he discussed authority in regards to relationships within firms.
  • Marx argued that the coercive authority of the boss over the worker limited the employee’s freedom.
  • In particular, he discussed how the hierarchical structure of the firm could reduce costs.

Contracts and relationships

How large are employment rents?

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

A contract for the sale of a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use and sell it to someone else. Under an employment contract, by contrast, an employee gives the employer the right to direct them to be at work at specified times, and authority over the use of their time while at work. The contract does not give the employer ownership of the employee—that would be slavery. To summarize:

  • Contracts for products sold in markets permanently transfer ownership of the good from the seller to the buyer.
  • Contracts for labour temporarily transfer authority over a person’s activities from the employee to the manager or owner.

In an employment contract, the worker is paid according to the time for which they work, not the specific tasks they undertake while working.

Employment differs from other market interactions in two other ways. In markets for goods, we shop around; our interactions with individual sellers or buyers are short-lived and often not repeated. An employment contract typically establishes a long-term relationship that may last years, decades, or even a lifetime. Figure 6.2 shows that in 2021, 42% of employees across 36 countries had been with their current employer for 10 years or more.

This bar chart shows the percentage of all employees according to the length of the time in their current job. The data is in the format: length of time, percentage of employees. Less than a month, 2%. Between 1 and 6 months, 8%. Between 6 and 12 months, 7%. Between 1 and 3 years, 13%. Between 3 and 5 years, 12%. Between 5 and 10 years, 14%. 10 years and over, 42%.
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Figure 6.2 Distribution of job tenure, 2021.

Calculations based on OECD. Employment by job tenure intervals – persons. Accessed January 2023.

incomplete contract
A contract that does not specify, in a way that can be enforced by a court, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

The second difference is that employment contracts are incomplete: they do not cover everything that the parties care about, such as how hard and well the employee will work, or whether the employee will quit or the employer terminate their job.

In subsequent sections, we will explore the reasons for these differences.

Exercise 6.1 The structure of an organization

In Figure 6.1 we showed the actors and decision-making structure of a typical firm.

  1. How might the actors and decision-making structure of three organizations, Google, Wikipedia, and a family farm compare with this?
  2. Draw an organizational structure chart in the style of Figure 6.1 to represent each of these entities.

Question 6.3 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

  • A labour contract transfers ownership of the employee from the employee to the employer.
  • Compared to sale contracts, employment contracts are typically long-term.
  • 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.
  • A firm is a structure that involves decentralization of power to the employees.
  • That would be slavery. A labour contract grants the firm the authority to direct the activities of the employee during specific times.
  • As shown in Figure 6.2, across many countries, most employment contracts last a year or more, with around 36% employees staying with their employer for ten or more years.
  • A labour contract gives the employer the authority to direct the activities of the employee, whereas a sale contract transfers property rights and does not bind the parties to further actions.
  • Firms represent a concentration of economic power in the hands of the owners and managers.
  1. Ronald H. Coase. 1937. ‘The Nature of the Firm’. Economica 4 (16): pp. 386–405. 

  2. Ronald H. Coase. 1992. ‘The Institutional Structure of Production’. American Economic Review 82 (4): pp. 713–19.