The organisation of the firm

Chapter
06
 Overview
I. Methods of Procuring Inputs
– Spot Exchange
– Contracts
– Vertical Integration
II. Transaction Costs
– Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
– Owners-Managers
– Managers-Workers
 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 this efficient mix of
inputs?
● How can the owners of a firm ensure that workers put
forth the maximum effort consistent with their
capabilities?
 Manager’s Role
▪ Procure inputs in the Costs
least cost manner, like
point B. C(Q)
▪ Provide incentives for A
workers to put forth $100
B
effort. 80

▪ Failure to accomplish
this results in a point like
A.
Q
▪ Achieving points like B 0 10
managers must
– Use all inputs efficiently.
– Acquire inputs by the least
costly method.
 Methods of Procuring Inputs
▪ Three methods managers can use to obtain inputs needed in
production: spot exchange, contracts, and vertical integration
▪ Spot Exchange
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.
Purchase the Inputs Using Spot Exchange

● One method of acquiring inputs is to use spot exchange.

Spot exchange occurs when the buyer and seller of an input
meet, exchange, and then go their separate ways. With the
spot exchange, buyers and sellers essentially are
“anonymous”; the parties may make an exchange without
even knowing each other’s names, and there is no formal
(legal) relationship between buyer and seller.
● A key advantage of acquiring inputs with spot exchange is
that the firm gets to specialize in doing what it does best:
converting the inputs into output.
 Purchase the Inputs Using Spot Exchange

● The input manufacturer specializes in what it does

best: producing inputs. Spot exchange often is used
when inputs are “standardized.” In that case, one
simply purchases the desired input from one of
many suppliers that will sell the input.

7
 Acquire Inputs under a Contract
● A contract is a legal document that creates an extended
relationship between a particular buyer and seller of an input. It
specifies the terms under which they agree to exchange over a
given time horizon, say, three years.
● By acquiring inputs with contracts, the purchasing firm enjoys
the benefits of specializing in what it does best because the other
firm actually produces the inputs the purchasing firm needs.
● This method of obtaining inputs works well when it is relatively
easy to write a contract that describes the characteristics of the
inputs needed. One key disadvantage of contracts is that they are
costly to write; it takes time, and often legal fees, to draw up a
8 contract that specifies precisely the obligations of both parties.
 Produce the Inputs Internally
● Finally, a manager may choose to produce the inputs needed for
production within the firm. . When a firm shuns other suppliers
and chooses to produce an input internally, it has engaged in
vertical integration.
● With vertical integration, however, a firm loses the gains in
specialization it would realize were the inputs purchased from an
independent supplier. Moreover, the firm now has to manage the
production of inputs as well as the production of the final product
produced with those inputs. This leads to the bureaucratic costs
associated with a larger organization. On the other hand, by
producing the inputs it needs internally, the firm no longer has to
9 rely on other firms to provide the desired inputs.
 Key Features

▪ Spot Exchange
– Specialization, avoids contracting costs, avoids costs of
vertical integration.
– Possible “hold-up problem.”
▪ Contracting
– Specialization, reduces opportunism, avoids skimping on
specialized investments.
– Costly in complex environments.
▪ Vertical Integration
– Reduces opportunism, avoids contracting costs.
 Demonstration Problem 6–1

● Determine whether the following transactions involve spot

exchange, a contract, or vertical integration:
● 1. Clone 1 PC is legally obligated to purchase 300 computer
chips each year for the next three years from AMI. 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.
● 2. Clone 2 PC purchased 300 computer chips from a firm that
ran an advertisement in the back of a computer magazine.
● 3. Clone 3 PC manufactures its own motherboards and computer
chips for its personal computers.
11
 Answer: 1.

● Clone 1 PC is using a contract to purchase its

computer chips.
● Clone 2 PC used spot exchange to acquire its
chips.
● Clone 3 PC uses vertical integration to obtain
its chips and motherboards

12
 Transaction Costs
▪ Costs of acquiring an input over and above
the amount paid to the input supplier.
▪ Includes:
– Search costs.
– Negotiation costs.
– Other required investments or
expenditures.
▪ Some transactions are general in nature
while others are specific to a trading
relationship.
 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.

14 6-
 Types of Specialized Investments

● Types of specialized investments

– Site specificity.
– Physical-asset specificity.
– Dedicated assets.
– Human capital.

6-
1
15 5
 Types of Specialized Investments
● Site Specificity
● Site specificity occurs when the buyer and the seller of an
input must locate their plants close to each other to be able to
engage in exchange.
● For example, electric power plants often locate close to a
particular coal mine to minimize the transportation costs of
obtaining coal.

16
 Types of specialized investments:
● Physical-asset Specificity
This refers to a situation where the capital
equipment needed to produce an input is designed to meet
the needs of a particular buyer and cannot be readily adapted
to produce inputs needed by other buyers.
Real World Example
For example, if an automobile engine requires a special part
that is useful only for producing the engine for a particular
buyer, the part is a specific physical asset for producing the
automobile engines.

17
 Types of specialized investments:
● Dedicated Assets
These are general investments made by a firm that allows it
to exchange with a particular buyer.
Real World Example
For example, a military weapon producer opens a new
assembly line to manufacturer guns for the United States
Department of Defense. If opening the assembly line is only
profitable if the government actually purchases the guns, the
investment represents a dedicated asset.

18
 Types of specialized investments:

● Human Capital
● A fourth type of specialized investment is human capital. In
many employment relationships, workers must learn specific
skills to work for a particular firm. If these skills are not
useful or transferable to other employers, they represent a
specialized investment.

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 Implications of Specialized
Investments

● Specialized investments increase transaction costs

because they lead to Implications of specialized
investments
– Costly bargaining.
– Underinvestment .
– Opportunism and the “hold-up problem.”

6-
2
20 0
 Costly Bargaining

● Costly bargaining is the process of negotiating pricing

between a buyer and a seller of a special input. The parties
may behave strategically to enchance their bargaining
position. For example, the buyer may refuse to accept
delivery to force the seller to accept a lower price. When
both parties have made specialized investments they are
locked into a relationship with each other. If one backs out of
the relationship both are hurt.

21
 Underinvestment

● Since specialized investments are only good for the relationship

between two parties (there is no value in any alternative use) then
the parties are likely to underinvest. For example, if company
XYZ purchases a special machine to make parts for company
ABC and the parts are no good to any other company other than
ABC then company XYZ may underinvest in the machine or
purchase an cheaper machine that produces lower quality parts
because it knows that if company ABC ever backs out of the
relationship then the machine is worthless
● When specialized investments are required to facilitate exchange,
the level of the specialized investment often is lower than the
22 optimal level.
 Opportunism and the “Hold-Up Problem”

● After a company makes a specialized investment the other

party involved in the exchange will likely try to be
opportunistic and take advantage of the situation by raise
prices of lowering quantity demands to better their position.
The company that made the investment is held up and has
little option other than to accept the current state because the
specialized investment is no good if the exchange does not
take place.
● When a specialized investment must be made to acquire an
input, the buyer or seller may attempt to capitalize on the
“sunk” nature of the investment by engaging in opportunism
23
 OPTIMAL INPUT PROCUREMENT

● How should a manager acquire inputs to

minimize costs?
– Depends on the extent of the relationship-specific
exchange.

24
 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.

25 6
 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.

26
 Optimal Contract Length In Action

MB, M
MC C
($)

M
B

0 Contract
27 6-
 Specialized Investments and
Contract Length In Action
MB,
M
MC
C
($)

M
Greater need for B1
specialized
M
investment
B0

0 Contract 6-
28 Length 2
 Specialized Investments and
Contract Length In Action
M M M
MB,
C1 C0 C2
MC
($) More Less
complex complex
contracting contractin
environme g
nt M
Benvironm
ent

Contract Length
0 Shorter contract Longer contract
 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.
– No longer specialized in producing its output. 6
30 3
 The Economic Trade-Off

● The cost-minimizing method of acquiring an

input depends on the characteristics of the
input. Whether a manager chooses spot
exchange or an alternative method such as a
contract or vertical integration depends on the
importance of the specialized investments that
lead to relationship-specific exchange

31
 The Economic Trade-Off

6-
3
32 2
 Compensation and the
Principal-Agent Problem
● The Principal-Agent Problem
– The principal-agent problem is the problem of devising
compensation rules that induce an agent to act in the best
interests of a principal.
– For example, the stockholders of a firm are the principals and
the managers of the firm are their agents.
● Coping with the Principal-Agent Problem
– Three ways of coping with the principal-agent problem are:
▪ Ownership
▪ Incentive pay

33 ▪ Long-term contracts
 Compensation and the
Principal-Agent Problem

– Ownership, often offered to managers, gives the

managers an incentive to maximize the firm’s profits,
which is the goal of the owners, the principals.
– Incentive pay links managers’ or workers’ pay to the
firm’s performance and helps align the managers’ and
workers’ interests with those of the owners, the
principals.
– Long-term contracts can tie managers’ or workers’
long-term rewards to the long-term performance of the
firm. This arrangement encourages the agents to work in
the best long-term interests of the firm owners, the
34 principals.
 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 6-
monitor. 3
35 5
 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 6-
compensated.
3
36 6
 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.

6
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3
7
 External Incentives

● Outside forces can provide manages with the incentive to

maximize profits, and include:
– Reputation.
– Managers have increased job mobility when they can
demonstrate to other firms that they have the managerial
skills needed to maximize profits. It is costly to be an
effective manager; many hours must be spent supervising
workers and planning production outlays.

38
 Takeover threat.

● Another external force that provides managers with an

incentive to maximize profits is the threat of a takeover. If a
manager is not operating the firm in a profit-maximizing
manner, investors will attempt to buy the firm and replace
management with new managers who will. By installing a
better manager, the firm’s profits will rise and the value of
the firm’s stock will increase.
● Thus, one cost to a manager of doing a poor job of running
the firm is the increased likelihood of a takeover. To avoid
paying this cost, managers will work harder than they
otherwise would, even if they are paid only a fixed salary
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 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.

40 6-
 Solutions to the Manager-Worker
Problem
● Manager-worker principal-agent problem
solutions:
– Profit sharing.
– Revenue sharing.
– Piece rates.
– Time clocks and spot checks.

41
 Solutions to the Manager-Worker
Problem
● Profit sharing
● Mechanism used to enhance workers’ efforts
that involves tying compensation to the
underlying profitability of the firm.
● Revenue sharing
● Mechanism used to enhance workers’ efforts
that involves linking compensation to the
underlying revenues of the firm

42
 Solutions to the Manager-Worker
Problem

● Piece Rates
● An alternative compensation method is to pay workers
based on a piece rate rather than on a fixed hourly wage. For
example, by paying a typist a fixed amount per page typed,
the payment to the typist depends on the output produced. To
earn more money, the typist must type more pages during a
given time period.

43
 Solutions to the Manager-Worker
Problem

● Time Clocks and Spot Checks

● Many firms use time clocks to assist managers in monitoring
workers. However, time clocks are generally not useful in
addressing the principal–agent problem. Time clocks
essentially are designed to verify when an employee arrives
and departs from the job. They do not monitor effort; rather,
they simply measure presence at the workplace at the
beginning and end of the workday

44
 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.

45 6