Managerial Economics & Overview

Business Strategy I. Methods of Procuring Inputs

Spot Exchange
Chapter 6

Contracts
Vertical Integration
The Organization of the Firm II. Transaction Costs
Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
Owners-Managers
Managers-Workers
Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.

Managers Role Methods of Procuring Inputs

Procure inputs in the
Spot Exchange
least cost manner Costs
When the buyer and seller of an input meet, exchange,
C(Q)
and then go their separate ways.
Provide incentives for A

workers to put forth

$100
B
Contracts
80
effort A legal document that creates an extended relationship
between a buyer and a seller.
Failure to accomplish
this results in a point Vertical Integration
like A Output When a firm shuns other suppliers and chooses to
0 $10
produce an input internally.

Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.

Key Features
Spot Exchange Transaction Costs
Specialization, avoids contracting costs, avoids costs of
vertical integration. Costs of acquiring an input over and above
Possible hold-up problem the amount paid to the input supplier.
Contracting Includes:
Specialization, reduces opportunism, avoids skimping Search costs
on specialized investments Negotiation costs
Costly in complex environments Other required investments or expenditures
Vertical Integration
Reduces opportunism, avoids contracting costs
Lost specialization, organizational costs

Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.

1
 Specialized Investments Specialized Investments
Investments made to allow two parties to and Contract Length
exchange but has little or no value outside of the
$
exchange relationship MC
Site specificity
Physical-asset specificity
Dedicated assets MB1
Human capital Due to greater need for
specialized investments
Lead to higher transaction costs and the problem MB0

of hold-up
Longer Contract

Contract
0 L0 L1 Length
Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.

Optimal Input Procurement The Principal-Agent Problem

Occurs when the principal cannot observe the
No
Spot Exchange effort of the agent
Substantial Example: Shareholders (principal) cannot observe the effort
specialized of the manager (agent)
investments
relative to Example: Manager (principal) cannot observe the effort of
Yes Complex contracting
contracting costs? environment relative to workers (agents)
costs of integration?
The Problem: Principal cannot determine
whether a bad outcome was the result of the
No Yes agents low effort or due to bad luck
Vertical
Contract Integration

Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.

Solving the Problem Between Solving the Problem Between

Owners and Managers Managers and Workers
Internal incentives Profit sharing
Incentive contracts Revenue sharing
Stock options, year-end bonuses
Piece rates
External incentives
Personal reputation
Time clocks and spot checks
Potential for takeover

Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc. Michael R. Baye, Managerial Economics and Business Strategy The McGraw-Hill Companies, Inc.