Chapter-6:

The Organization of The Firm

by Traheka Erdyas Bimanatya, M.Sc.

Managerial Economics | 11 April 2019

Outline
―Optimal Input Procurement
▪ Transaction Costs
▪ Evaluating Methods of Procuring Inputs
― The Principal-Agent Problem
▪ What is it?
▪ Solution

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PART 1:
OPTIMAL INPUT PROCUREMENT
Choosing optimum input is necessary, but not sufficient

To minimise cost, you need

to:
1. have the most efficient
input procurement;
2. encourage workers to
give their best effort.

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How could we have the most efficient input procurement?
By having a method that have the lowest transaction cost given input
prices and quality of products.

Suppliers
▪ Prices
▪ Quality
▪ Transaction Costs

Output

Input Managerial Economics |5

What types of input procurements we can choose?
1. Spot exchange
‒ An informal relationship between a buyer and seller in which neither
party is obligated to adhere to specific terms for exchange.

2. Contract
‒ A formal relationship between a buyer and seller that obligates the
buyer and seller to exchange at terms specified in a legal
document.

3. Produce inputs internally (vertical integration)

‒ A situation where a firm produces the inputs required to make its
final product.
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What is transaction costs?
Cost associated with acquiring an input that is in excess of the amount
paid to the input supplier.
Transaction Costs

Obvious (General)
Hidden (Specific)
▪ Cost of searching for a supplier. ▪ Specialized investment:
▪ Cost of negotiating a price. – Site specificity
▪ Investments and expenditures required to – Physical-asset specificity
facilitate exchange.
– Dedicated assets
– Human capital
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Why we need to care about specialized investment ?
1. It makes a costly bargaining problem.
‒ Only few suppliers that are capable to provide.
‒ No market prices!

2. Suppliers may do underinvestment problem.

‒ because this investment only serve few buyers.
‒ produces an input of inferior quality.

3. Both parties can behave in an opportunistic way.

‒ There is sunk cost in specialized investment
‒ They will try to take advantages to each other.
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How should a manager acquire inputs to minimize costs? #1
▪ If there is specialized investment, why
not choose Spot Exchange?
– Opportunism problem
– Underinvestment in specialized
investments

▪ If contracting environment is complex,

why not choose contract?
‒ Typically requires substantial up-
front expenditures.
‒ Requires decision on optimal
contract length
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How do we determine the optimal contract length ?
▪ The marginal benefit (MB) of extending
a contract is:
‒ Reduces likelihood of opportunism.
‒ Reduces likelihood to skimp on
specialized investment

▪ The marginal cost (MC) of extending a

contract is:
‒ More resources and time to write a
specific longer contract.
‒ Because of uncertainty in the future
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What happens if there is changes in MC and MB ?

Changes in MB Changes in MC

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The advantages and disadvantages of vertical integration
Advantages: Disadvantages:

▪ “Skips the middleman” ▪ Managers must create an

internal regulatory mechanism
▪ Reduces opportunism
▪ Bear the cost of setting up
▪ Mitigates transaction production facilities
costs
▪ No longer specialized in
producing its output
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Q & A #1
ANY QUESTIONS UP TO THIS
POINT?
PART 2:
THE PRINCIPAL-AGENT PROBLEM
What is Principal-Agent Problem ?
If the owner is not present to monitor the manager, how can she
get the manager to do what is in her best interest?

▪ Manager’s economic
trade-off:
1) Leisure.
2) Labor

▪ Fixed salary
‒ Receives wage
independent of labour
hours and effort.
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Owners have to encourage managers since they are not present
to monitor
Incentive Contracts
▪ Tie manager wage to
firm performance e.g.
profit sharing, revenue-
based performance.
External Incentives
▪ Outside forces can
provide managers with
the incentive to
maximize profits e.g.
reputation, takeover
threat.
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The case of using profit sharing

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Alternative approaches to encourage manager’s best efforts
1. Revenue sharing e.g. tips and sales commissions.
‒ effective when worker productivity is related to revenue (restaurant’s
servers)
‒ However, it does not provide incentive for workers to minimise cost.

2. Piece rates e.g. wrapping a gift, data entry.

‒ Quite simple.
‒ Causes quantity over quality problem.

3. Time clocks and spot checks.

‒ Time clocks only monitor attendance rate but not the “real working hour”
‒ Spot checks is more effective if conducted randomly and frequently.

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Q & A #2:
ANY QUESTIONS UP TO THIS
POINT?
 THANK YOU
Traheka Erdyas Bimanatya, M.Sc. traheka.erdyas.b@ugm.ac.id

Traheka Erdyas Bimanatya