CHAPTER 6

The Organization of
the Firm

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Overview
Chapter Outline
• Methods of procuring inputs
– Purchase inputs using spot exchange
– Acquire inputs under a contract
– Produce inputs internally
• Transaction costs
– Types of specialized investments
– Implications of specialized investments
• Optimal input procurement
– Spot exchange
– Contracts
– Vertical integration
– Economic tradeoff
• Managerial compensation and the principal-agent problem
• Forces that discipline managers
– Incentive contracts
– External incentives
• Manager-worker principal-agent problem
– Solutions to the manager-worker principal-worker problem

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 Chapter Overview
Introduction
• Chapter 5 focused on how to select the mix of
inputs that minimizes the cost of production.
• This chapter addresses the following two
questions:
– What is the optimal way to acquire the efficient
mix of inputs?
– How can owners of a firm ensure that workers put
forth maximum effort consistent with their
capabilities?

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 Introduction

Management’s Role
Producing at Minimum Cost
Costs Minimum
($) cost function

$100 A

B
$80

0 10 Output

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 Methods of Procuring Inputs

Methods of Procuring Inputs

• Spot market
– An informal relationship between a buyer and
seller in which neither party is obligated to adhere
to specific exchange.
• Contract
– A formal relationship between a buyer and seller
that obligates the buyer and seller to exchange at
terms specified in a legal document.
• Produce inputs internally (vertical integration)
– A situation where a firm produces the inputs
required to make its final product.

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 Methods of Procuring Inputs

Methods of Procuring Inputs In Action

• Determine whether the following transactions involve spot
exchange, a contract, or vertical integration:
– Clone 1 PC is legally obligated to purchase 300 computer chips
each year for the next 3 years from AML. The price paid in the
first year is $200 per chip, and the price rises during the second
and third years by the same percentage by which the wholesale
price index rises during those years.
– Clone 2 PC purchased 300 computer chips from a firm that ran
an advertisement in the back of a computer magazine.
– Clone 3 PC manufactures its own motherboards and computer
chips for its personal computers.
• Answers:
– Clone 1 PC is using a contract.
– Clone 2 PC used the spot exchange.
– Clone 3 PC uses vertical integration.

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 Transaction Costs
Transaction Costs
• Cost associated with acquiring an input that is
in excess of the amount paid to the input
supplier.
• Types of “obvious” transaction costs
– Cost of searching for a supplier.
– Cost of negotiating a price.
– Investments and expenditures required to
facilitate exchange.

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 Transaction Costs
Types of “Hidden” Transaction Costs
• Specialized investment
– Expenditure that must be made to allow two
parties to exchange but has little or no value in
any alternative use.
• Relationship-specific exchange
– A type of exchange that occurs when the parties
to a transaction have made specialized
investments.

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 Transaction Costs

Types of Specialized Investments

• Types of specialized investments
– Site specificity.
– Physical-asset specificity.
– Dedicated assets.
– Human capital.

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 Transaction Costs

Implications of Specialized Investments

• Implications of specialized investments
– Costly bargaining.
– Underinvestment .
– Opportunism and the “hold-up problem.”

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 Optimal Input Procurement
Optimal Input Procurement
• How should a manager acquire inputs to
minimize costs?
– Depends on the extent of the relationship-specific
exchange.

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 Optimal Input Procurement
Spot Exchange
• Characteristics of the spot exchange:
– No relationship-specific investment.
– Absence of transaction costs, and many buyers
and sellers, imply that the market price is
determined by the intersection of demand and
supply.
– Opportunism.
– Underinvestment in specialized investments.

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 Optimal Input Procurement
Contracts
• Characteristics of contracts:
– Use when inputs require a substantial specialized
investment.
– Typically requires substantial up-front
expenditures.
– Specifies prices of inputs prior to making
specialized investments.
• Reduces likelihood of opportunism.
• Reduces likelihood to skimp on specialized investment.
– Requires decision on optimal contract length.

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 Optimal Input Procurement

Optimal Contract Length In Action

MB, MC MC
($)

MB

0 𝐿∗ Contract Length
(in years)

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 Optimal Input Procurement

Specialized Investments and

Contract Length In Action
MB, MC
($) MC

MB1
Greater need for
specialized investment
MB0

0 𝐿0 𝐿1 Contract Length

Longer contract
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 Optimal Input Procurement
Specialized Investments and
Contract Length In Action
MC1 MC0 MC2
MB, MC
($)
More complex
Less complex
contracting
contracting
environment
environment

MB

0 𝐿1 𝐿0 𝐿2 Contract Length

Shorter contract Longer contract

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 Optimal Input Procurement

Vertical Integration
• Produce inputs internally.
• Use when inputs require
– a substantial specialized investment.
– generate significant transaction cost.
– complex contracting or uncertain economic environments.
• Advantages:
– “Skips the middleman.”
– Reduces opportunism.
– Mitigates transaction costs.
• Disadvantages:
– Managers must create an internal regulatory mechanism.
– Bear the cost of setting up production facilities.
– No longer specialized in producing its output.

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 Optimal Input Procurement
The Economic Trade-Off
Substantial specialized
investment relative to
contracting costs?

Complex contracting
Spot exchange environment relative to
cost of vertical integration

Contract

Vertical integration

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 Managerial Compensation and the Principal Agent Problem
Compensation and the
Principal-Agent Problem
• Having learned about the principal factors in
selecting the best methods of acquiring inputs, we
now explain how to compensate labor inputs to put
forth maximal effort.
• The primary obstacle is the separation of ownership
and control.
– Principal-agent (P-A) problem leads to the following
question: Is poor performance due to
• back luck?
• low manager effort?
– Owners have to incent managers since they are not
present to monitor.
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 Managerial Compensation and the Principal Agent Problem

Managers’ Compensation Mechanisms

• Manager’s economic trade-off
– Leisure.
– Labor.
• Fixed salary
– Receives wage independent of labor hours and effort.
• No strong incentive to monitor other employees labor hours
and effort.
• Adversely impacts firm performance.
• Incentive contract
– Tie manager wage to firm performance (like profits).
– Manager makes labor-leisure choice and is accordingly
compensated.
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 Forces that Discipline Managers

Incentive Contracts
• A way to align owners’ interests with that of
the actions of its manager.
• Examples include:
– Stock option
– Other bonuses directly related to profits.

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 Forces that Discipline Managers

External Incentives
• Outside forces can provide manages with the
incentive to maximize profits, and include:
– Reputation.
– Takeover threat.

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 The Manager-Worker Principal-Agent Problem
The Manager-Worker
Principal-Agent Problem
• The owner-manager, principal-agent problem
is not unique.
– A similar problem exists between the firm’s
managers and the employees he or she
supervises.

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 The Manager-Worker Principal-Agent Problem

Solutions to the Manager-Worker Problem

• Manager-worker principal-agent problem
solutions:
– Profit sharing.
– Revenue sharing.
– Piece rates.
– Time clocks and spot checks.

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 Introduction

Management’s Role
Costs Minimum
($) cost function

$95 A

B
$75

0 150 Output

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 Conclusion
• The optimal method for acquiring inputs
depends on the nature of the transaction
costs and specialized nature of the inputs
being produced.
• To overcome the owner-manager and
manager-worker principal-agent problems,
principals must align the agents’ interests with
the principals’ interests.

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