Business Organizations - BUSINESS ORGANIZATIONS Fall 2005 I...

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BUSINESS ORGANIZATIONS Fall 2005
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I. THE FIRM A. Definition 1. Coasean : set of relations that arise when resources are allocated by the entrepreneur via commands to employees rather than the set of relations that arise when an entrepreneur allocates resources via contract with outsiders (i.e. a firm is the antithesis of the market) 2. Nexus of Contracts : nexus of contracts between the various claimants to a share of the gross profits generated by the business B. Sole Proprietorship v. Business Organization 1. Sole Proprietorship : one person owns 100% of the business (i.e. one person keeps all the profits and bears all losses) 2. Business Organization : jointly owned firm that uses more than simple market transactions and contractual exchanges to organize the means of production C. Business Organizations Law 1. protects the reasonable expectations of individuals who jointly own firms 2. provides off-the-rack solutions to common sets of organizational problems 3. defines a series of different organizational forms 4. contains both mandatory and default rules D. Business Lawyer Responsibilities 1. understand client’s economic goals and partner-investor relationships 2. design an organization that suits their needs and that will protect them if disputes should arise 3. use the different forms of business associations and the default rules 4. organization type will determine the legal relationships of the participants, their responsibilities for business debts, and their tax liability – will only really matter when something breaks down E. Expected Return 1. Problem : owners desire a reasonable return on their investment of human or money capital, but choice of where to invest capital is based on incomplete knowledge due to ex ante decision making 2. Expected Return : likely return from alternative investment choices (multiply each possible return by its probability, then add together the products) 250,000 Capital (By Choice) Return Probability/Risk Average $500,000 .25 $125,000 $32,000 .75 $24,000 Expected Return $149,000 250,000 Capital (By Guessing) Return Probability/Risk Average $500,000 .5 $250,000 $32,000 .5 $16,000 Expected Return $266,000 1
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F. Risk and Return 1. investments with more than one possible return have risk 2. risk increases as the possible range of possible outcomes increases and as the likelihood that actual and expected return will differ increases 3. risk neutral – indifferent when risks are the same 4. risk averse – wants less risky investment 5. risk preferring – wants riskier investment G. Transaction Costs 1. Flexibility : flexibility and adaptability of efficient business structures help to minimize transaction costs 2. Bounded Rationality : investors are unable to anticipate and plan for every contingency that might effect their venture 3. Opportunism : one participant might try to take advantage of the information deficits of the other (i.e. self-interested behavior with guile) 4. Team Specific Investment : investment is team specific if and to the extent that the investment has a lesser value if re-deployed outside the team (a)
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