6/8/21

Size and structure of firms

Industrial Organization (A - B)
Professor: Julio Aguirre
Period: 2021-I

Content
1. The Neoclassic view (Viner, 1932)
2. The firm as a long-run relationship
a. Idiosyncratic investment and asset specificity
b. ex-post transaction costs
c. ex-ante transaction costs
d. Limitations of long-run relationship
3. The firm as an incomplete contract

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1. The Neoclassic view (Viner, 1932)

a. Theoretical foundations
• Viner (1932): the size and the number of the firms in an industry are
related to the degree of returns of scale.
• Such economies of scale, related to the volume of a single product,
are called “product-specific economies”. In the multiproduct case:
“economies of scope”.
• There exists an efficient size for each firm, which is given by
engineering factors which define the production set.
• Demand complementarities may also be a motive for coordinating
activities (U-form): synergies.

Source: Tirole (1988)

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a. Theoretical foundations
i. Single-production (1/2)

Source: Tirole (1988)

𝐶 𝑞 = 𝐹 + 𝑞 ! 𝑎,
𝐶 𝑞 = 𝐹 + 𝑐𝑞, ∀𝑞 > 0 (𝑎 > 0)
MES: Most Efficient Scale

a. Theoretical foundations
i. Single-production (2/2)
"
#
𝐶 𝑞 = 𝐹 + & 𝐶 𝑥 𝑑𝑥 𝑓𝑜𝑟 𝑞 > 0
!
0 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
F ≥ 0 denotes a fixed production cost.

Marginal costs are strictly decreasing if 𝐶 ## 𝑞 < 0 , ∀ possible q.

&("!) &("")
Average costs are strictly decreasing if, for 𝑞$ and 𝑞% , such that 0 < 𝑞$ < 𝑞% , "!
< ""

• Every-where decreasing marginal costs imply every-where decreasing average costs. The converse
of this proposition, however, is false.

• C(q) is said to be strictly subadditive if, for any n-tuple of outputs 𝑞$ , … , 𝑞) , ∑)*+$ 𝐶 𝑞* > 𝐶 ∑)*+$ 𝑞* ,
meaning that it costs less to produce various outputs together than to produce them separately.

• Every-where decreasing average cost imply subadditivity. The converse of this proposition, however,
is false.

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a. Theoretical foundations
ii. Multiproduct firm

Subadditivity: in the multiproduct case, economies of scale are neither necessary nor
sufficient for cost to be subadditive, because interdependence among outputs is important!

• Let q denotes a production vector or plan: 𝒒 = (𝑞! , … , 𝑞" ) for the m outputs, and 𝒒𝟏 , … , 𝒒𝒏
denote n such vectors,

The cost function C is strictly subadditive if ∑'%&! 𝐶 𝒒𝒊 > 𝐶 ∑'%&! 𝒒𝒊 ∀ 𝑞 such that ∑% 𝑞% ≠ 0

Economies of scope:

• Let 𝑞! and 𝑞) denote two quantities of two different goods, thus for a strictly subadditive
cost function, 𝐶 𝑞! , 0 + 𝐶 0, 𝑞) > 𝐶(𝑞! , 𝑞) )

• Economies of scope are a necessary for cost to be subadditive in the multiproduct case.

Total cost

Output Y

Ouput X

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Total cost Decreasing average costs

Decreasing
average cost X

Total cost

a
a: diseconomies of
scope.

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Total cost Complementarity in production

a
a: economies of
scope

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2. The firm as a long-run relationship

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a. Idiosyncratic investment and asset specificity (1/3)

• Switching costs (Williamson, 1976).

• Switching costs are a case of idiosyncratic investment: once the two parties
have traded, staying together can yield a surplus relative to trading with other
parties.

• Examples: (i) reluctance to transmit information to the new one unit; (i)
granting concessions (to avoiding repeating bidding).

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a. Idiosyncratic investment and asset specificity (2/3)

• Idiosyncratic investment can be associated with the prospect of future trading rather than with
current trading. For instance:

Ø When a supplier must design equipment the characteristics of which are specific
(dedicated) to a buyer’s particular order, or

Ø When a buyer spends money and effort to sell or promote a final product in advance., or

Ø When a user of a raw materials buy machines that are adapted to the use of certain
materials.

• Williamson (1975) distinguishes two further types of specificity:

Ø site-specificity

Ø specific investments in human capital

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a. Idiosyncratic investment and asset specificity (3/3)

• Outcome: the parties that contract now know that later on there will be gains from trade
between them to be exploited. It is important that these gains from trade be exploited
correctly (i.e., that there be an efficient amount of trade ex post) and that they be
divided properly in order to induce the efficient amount of specific investment ex
ante.

• Under bilateral monopoly, each party wants to appropriate the common surplus ex post,
thus jeopardizing the efficient realization of trade ex post and the efficient amounts
of specific investments ex ante.

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b. ex-post transaction costs

Assumptions:
• Two periods: 𝑡 = 1 (ex ante) and 𝑡 = 2 (ex post).
• A supplier/buyer may/may not contract in 𝑡 = 1.
Supplier
• To focus in the ex post issue, we ignore for the moment 𝑡 = 1 specific
investments. 𝑝≥𝑐
• At the beginning of period 2, the two parties learn how much they will gain
from trading in 𝑡 = 2.
• If they choose to do so, they trade one unit of an indivisible good (or the
supplier realizes a project).
• Volume of trade is either 0 or 1.
• v is the value of the good to the buyer; c is the production cost to the
supplier. Buyer
• The gains from trade (if any) to be split: 𝑣 − 𝑐 = 𝑝 − 𝑐) + (𝑣 − 𝑝 𝑣≥𝑝
• 𝑝 − 𝑐: the seller’s surplus; 𝑣 − 𝑝: the buyer’s surplus.

Bargaining? contracting?

H0: Ex post bargaining may not lead to the efficient volume of trade. Some constraints on the
second-period decision process must be contracted for. The power should go to the informed
party.

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c. ex ante transaction costs

• Even c and v could be known by both parties in t=2, there remains the problem of investment
decisions in t=1 (i.e., before gargaining of price and the volume to trade).

• Those decisions are very important when investments are specific to the relationship between
supplier and buyer, because it cannot be sold/purchased to/from a third party.

• When one of the parties makes this kind of investments, hold-up problem can arise.

H0: The party investing should have the authority over the price, or over the trading decision if
the other party’s information is known in advance.

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Example 1 - Assumptions:
• At 𝑡 = 1 a supplier invest in cost reduction (his investment reduces c) and a buyer invest in value enhancement (his
investment increases v). They are “specific investments”.

Ø The supplier can reduce its production cost with more investments: 𝑐(𝑖), such that 𝑐# 𝑖 < 0 and 𝑐## 𝑖 > 0.

Ø Once the supplier decided to invest i, it is expected that the total gains from trade, 𝑣 − 𝑐 𝑖 will increase.

Ø Albeit the buyer could have an opportunistic behavior and the intention to renegotiate the price p with the aim of increase: [𝑣 − 𝑝].

Ø NE for this bargaining defines the prices p from: 𝑣 − 𝑝 = 𝑝 − 𝑐 𝑖 .

[% & '(]
Ø 𝑝(𝑖) = *
. This price will be considered by the supplier, ex ante, when he has to decide the optimum amount of investment i.

( %(&)
Ø 𝑀𝑎𝑥& 𝑝 𝑖 − 𝑐 𝑖 − 𝑖 = * − *
− 𝑖.

%! &
Ø FOC:− *
− 1 = 0 → −𝑐# 𝑖 = 2.
Ø In contrast, the socially optimal investment solves: 𝑚𝑎𝑥& 𝑣 − 𝑐 𝑖 − 𝑖, with FOC: −𝑐# 𝑖 − 1 = 0 → −𝑐# 𝑖 = 1.

Ø The problem is that the party investing does not capture all the cost savings (increments in value) generated by his investment
given potential opportunism by buyer.

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Whether the supplier anticipates an opportunist behavior by the buyer trying to ex post renegotiate the price, the supplier
maximizes profit when −𝑐 # 𝑖 = 2, that is, to invest 𝑖 - . The social optimal level should be increase expenditure of
investment up to −𝑐 # 𝑖 = 1, that is 𝑖 ∗ > 𝑖 - .

Source: Fernández-Baca (2006).

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• Example 2: The model also allows us to see the effect of the degree of asset specificity and
the existence of outside opportunities.

• Case 1:
Ø A large number of buyers who all are willing to pay v for the good.
Ø There is asset specificity through an investment, i, for a particular a “the specific buyer”.
Ø If the supplier trades with any other buyer, his production cost is: 𝜆𝑖, such that 𝜆 ∈ (0,1). [𝜆 = 0
is the most extreme form of asset specificity, and 𝜆 = 1 corresponds to the absence of
specificity]
Ø Suppose supplier has invested i. By not trading with the specific buyer, he obtains price v and
gets surplus 𝑣 − 𝑐 𝜆𝑖 .
Ø Bargaining with the with the specific buyer at price p such that price leads to an equal division
$
of the total gains from trade: 𝑣 − 𝑝 = 𝑝 − 𝑐 𝑖 − 𝑣 − 𝑐 𝜆𝑖 ⟹ 𝑝 = 𝑣 + % [𝑐 𝑖 − 𝑐 𝜆𝑖 ].
$
Ø After replacing p in the supplier’s intertemporal payoff, we get: 𝑣 − % 𝑐 𝑖 + 𝑐 𝜆𝑖 − 𝑖. Thus, ex
ante choice of investment yields − 𝑐 # 𝑖 + 𝜆𝑐 # 𝜆𝑖 = 2.
Ø When 𝜆 = 1 (no asset specificity), 𝑝 = 𝑣 and the investment is socially optimal.
Ø When 𝜆 = 0 (full asset specificity), the investment level is the same as in the absence of
outside opportunities.

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• Caso 2:
Ø Let us suppose that 𝛼 and 1 − 𝛼 represents the percentage of sales from supplier to an
specific buyer and to a group of buyers in a competitive market, respectively.

Ø The sales to the specific buyer take place at a price 𝑝 < 𝑣, and in the second case, at a price
𝑝 = 𝑣. The Nash Equilibrium is: 𝑣 − 𝑝 = 𝛼 𝑝 − 𝑐 𝑖 + (1 − 𝛼)[𝑣 − 𝑐 𝑖 ].

,-./(*)
Ø Thus, the price is 𝑝 = $.,
.

Ø The supplier’s profit function in order to determine the investment to be realized is:
𝛼 𝑝 − 𝑐 𝑖 + 1 − 𝛼 𝑣 − 𝑐 𝑖 − 𝑖.

,!.,/(*)
Ø After replacing the price (ex post) 𝑝: $.,
− 𝑐 𝑖 + 1 − 𝛼 𝑣 − 𝑖.

Ø FOC: −𝑐 # 𝑖 = 1 + 𝛼.

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d. Limitations of long-run relationship

• The presence of outside opportunities.

• Collusion between the units.

• A short-term relationship is generally more advantageous given good

outside opportunities.

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3. The firm as an incomplete contract

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• Coase (1937) and Williamson (1975) have distinguished four types of

transaction costs:

i. Some contingencies which parties will face may not be foreseeable at

Which occur at
the contracting date. the
contracting
date.
ii. Even if they could be foreseen, there maybe too many contingencies
to write into the contract.

iii. Monitoring the contract maybe costly. Which occur

later

iv. Enforcing contracts may involve considerable legal costs.

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Aguirre (2012)

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• Two cases of decision process that, ex post, handle the unforeseen contingencies:

– (i) bargaining

– (ii) intermediate forms of contracting:

• Arbitration

• Authority

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Grossman and Hart (1986)

Assumptions:
Ø We have two physical assets a1 and a2, operated by two managers M1 and M2,
respectively.
Ø M1 with a1 produces one unit of input purchased by M2. This manager with a2
produces a final output that is sold to final consumers.
Ø Before any relationship both physical assets are already installed, such that the
specific investments improve the productivity of those assets.
Ø There is symmetric information: each firm knows costs and benefits of each other.
However, there is uncertainty about the quality of the delivered input and this makes
difficult to establish a long-term contract.
Ø The transaction has two periods: 0 and 1. The specific investments are realized in
period 0 and the input is produced and sold in period 1.
Ø Both firms are risk neutral and there exist a perfect capital market (no one has
restrictions to make purchasing decisions about the assets more convenient for them).
Ø Given the above, there are three possible structures:
o Type 0 No integration: M1 is the owner of a1 and M2 is the owner of a2
o Type 1 integration: M1 is the owner of a1 and a2.
o Type 2 integration: M2 is the owner of a1 and a2.
Final consumers
Ø If the no integration maximizes the total surplus obtained from trade between both
parties, then any form of integration is inefficient. The firms will prefer any agreement
regarding price of input or specific investment financing, rather than any alternative of
integration.

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Ø(A) Investments and yield of firms

ØLet be e the volume of specific investments of M1, which reduces the production cost of
input that is sold to M2 at a price p.

ØThus, 𝐶 𝑒 < 𝑐 𝑒, 𝑎1, 𝑎2 < 𝑐 𝑒, 𝑎1 < 𝑐 𝑒, 𝜙 → −𝐶 A 𝑒 > −𝑐 A 𝑒, 𝑎1, 𝑎2 > −𝑐 A 𝑒, 𝑎1 >

− 𝑐′(𝑒, 𝜙)

ØLet be 𝑖 the volume of specific investments by M2, which contributes improving the
price for final consumer and M2’s revenues R.

ØThus, 𝑅 𝑖 > 𝑟 𝑖, 𝑎1, 𝑎2 > 𝑟 𝑖, 𝑎2 > 𝑟 𝑖, 𝜙 → 𝑅 A 𝑖 > 𝑟 A 𝑖, 𝑎1, 𝑎2 > 𝑟 A 𝑖, 𝑎2 > 𝑟′(𝑖, 𝜙).

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Ø (B) Division ex post of gains

Ø Total gains from trade between both firms: 𝑅 𝑖 − 𝑝 + 𝑝 − 𝐶 𝑒 = 𝑅 𝑖 − 𝐶 𝑒

Ø Total gains when both firms do not trade and each one make transaction with other firms:
𝑟 𝑖 − 𝑝̅ + 𝑝̅ − 𝑐 𝑒 = 𝑟 𝑖 − 𝑐(𝑒).

Ø Given 𝑐 𝑒 > 𝐶(𝑒) and 𝑟 𝑖 < 𝑅(𝑖): 𝑅 𝑖 − 𝐶 𝑒 > 𝑟 𝑖 − 𝑐(𝑒).

Ø The Nash Equilibrium determines they split the total gains:

𝑝 − 𝐶 − 𝑝̅ − 𝑐 = (𝑅 − 𝑝 − (𝑟 − 𝑝)]. ̅
$ $
Ø Thus, 𝑝 = 𝑝̅ + 𝑅 − 𝑟 − (𝑐 − 𝐶)
% %
Ø And each firm earns the following profits:
$ $
𝜋$ = 𝑝 − 𝐶 − 𝑒 = 𝑝̅ + 𝑅 − 𝑟 − (𝐶 + 𝑐) − 𝑒
% %

$ $
𝜋% = 𝑅 − 𝑝 − 𝑖 = 𝑅+𝑟 − 𝐶 − 𝑐 − 𝑝̅ − 𝑖
% %

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Ø In an optimal world, without transaction costs, both firms choose their specific investments acting cooperatively,
maximizing conjoint profits from their commercial relationship: 𝑚𝑎𝑥&,0 𝑅 𝑖 − 𝐶 𝑒 − 𝑖 − 𝑒. The FOC: 𝑅 # 𝑖 ∗ = 1 and
− 𝐶 # 𝑒 ∗ = 1.

Ø In a world with incomplete contracts and in which each party chooses its specific investments in a no cooperative
way, the FOC are:

1 1 1 1
𝜋1 = 𝑝 − 𝐶 − 𝑒 = 𝑝 + 𝑅 − 𝑟 − 𝐶 + 𝑐 − 𝑒 ⟹ 𝐹𝑂𝐶: − 𝐶 " 𝑒 − 𝑐 " 𝑒 = 1
2 2 2 2

1 1 1 1
𝜋* = 𝑅 − 𝑝 − 𝑖 = 𝑅 + 𝑟 − 𝐶 − 𝑐 − 𝑝 − 𝑖 ⟹ 𝐹𝑂𝐶: 𝑅 # 𝑖 + 𝑟 # 𝑖 = 1
2 2 2 2

Ø Thus, three cases arise:

1 1 1 1
(1º) No integration (type 0): the FOC are, − 𝐶 # 𝑒- − 𝑐 # 𝑒- , 𝑎1 = 1 and 𝑅 # 𝑖- + 𝑟 # 𝑖- , 𝑎2 = 1
* * * *

1 1 1 1
(2º) Type 1 integration: the FOC are, − 𝐶 # 𝑒1 − 𝑐 # 𝑒1 , 𝑎1, 𝑎2 = 1 and 𝑅 # 𝑖1 + 𝑟 # 𝑖1 , 𝜙 = 1
* * * *

1 1 1 1
(3º) Type 2 integration: the FOC are, − 𝐶 # 𝑒* − 𝑐 # 𝑒* , 𝜙 = 1 and 𝑅 # 𝑖* + 𝑟 # 𝑖* , 𝑎1, 𝑎2 = 1
* * * *

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Grossman and Hart (1986)

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Grossman and Hart (1986)

Ø If the non-cooperative equilibria is not feasible, but both parties can arrive to ex ante agreements, the best
structure of property will be that with the highest total surplus, net of expenditures in investments.

𝑆! = 𝑅 𝑖! − 𝑖! − 𝐶 𝑒! − 𝑒!

𝑆$ = 𝑅 𝑖$ − 𝑖$ − 𝐶 𝑒$ − 𝑒$

𝑆% = 𝑅 𝑖% − 𝑖% − 𝐶 𝑒% − 𝑒%

Ø Thus, with low costs of transaction in an agreement, firms will choose that structure of property with the
highest total surplus whatsoever the initial situation is (Coase, 1960).

Ø For instance, if the initial situation is no integration, and both parties see that 𝑠$ = 𝑀𝑎𝑥(𝑆!, 𝑆$, 𝑆%), they reach
an agreement in which M1 buys a2, that is, a type 1 integration in exchange of a payment T:

𝑆$ − 𝑇 > 𝑝 − 𝐶 𝑒! − 𝑒!

𝑇 > 𝑅 𝑖! − 𝑝 − 𝑖!

Ø Adding up these equations let us to verify that 𝑆$ > 𝑆!. This lets M1 propose to M2 a price for a2: 𝑇 < 𝑆$ −
𝑆!. [You can demonstrate that: given that 𝑆$ > 𝑆%, for M2 is not convenient to buy a1 as a type 2 integration
structure].

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Grossman and Hart (1986)

ØIf one person is fully responsable for the performance of an asset, then this person
should be the owner.

ØIf there are managerial increasing returns inside the firm so that person can manage the
two companies, both companies must be integrated.

ØIf transactions between M1 and M2 are only a fraction of their respective business, they
can implement short-term or long-term contracts.

ØMerger is an option when the industry is in a phase of decline, in order to save

expenditures.

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