teach

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sébioihboigiaouasprelation
"
"l TH
demand , "

elasticity /µ?¥easµlelastic
E1
demanded -1

Chapter 3 quantity
Itt

\ unitary

Production and cost analysis; 1

Click to add text
Click to addtt

The organization of a firm relationship quaintly

and price change

demanded

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 relationship quantity demanded and price
change

⇐→
elastic inelastic
t ti
xañgdaii
tñnylgiaingiéthi ☒ VN
,
quantity demanded gianni
siithayotoi
?
t

cdcaimoithañgsubslitndl Hong quantity demanded

I giaunqnbueii
total revenue I
totalrevenuetañg
→ Xaidtnfslñcmentañggiasanphaiinhayovñtañg tong
muiomño
toiotahoaloiinhua.in → doanhthuchitanphñn

✗ tñiuihoiquylrinissañxuai
'

tiitmhoaqvytrint.si
 “
Part 1.
Production and cost analysis

threebin nhñncoug
u-thumualeaonheaimguginvai.hai.at
thru mna
mi vai voi

nhi thinai
2
 Basic Concepts of Production Theory

◎ Inputs are considered variable or fixed depending on how

readily their usage can be changed
◎ Variable input
○ An input for which the
Bấm để level
thêm nộiof usage may be changed quite readily
dung
◎ Fixed input
○ An input for which the level of usage cannot readily be changed and
which must be paid even if no output is produced
◎ Quasi-fixed input
○ An input employed in a fixed amount for any positive level of
output that need not be paid if output is zero

8-3
 Basic Concepts of Production Theory
SR
labor is variable can be changed in the
◎ Short run
○ At least one input is fixed → capital fixed can not change in SR
○ All changes in output achieved by changing usage
of variable inputs
◎ Long run
○ All inputs are variable
○ Output changed by varying usage of all inputs

8-4
1.
Production and Cost
in the Short Run

5
 Short Run Production

◎ In the short run, capital is fixed

○ Only changes in the variable labor input can
change the level of output
◎ Short run production function

Q = f ( L,K ) = f ( L )

8-6
 Average & Marginal Products
Total Product is
◎ Average product of labor
○ AP = Q/L
maximize
◎ Marginal product of labor
○ MP = DQ/DL t
◎ When AP reaches it maximum: " MP = 0
○ AP = MP → main glu.isañxuataia moi labor
◎ Law of diminishing marginal product
○ As usage of a variable input increases, a point is
reached beyond which its marginal product decreases

trig thnixvñoyimuoñcuamoinha quasi ty 8-7

 cd3QD-IAPmaximumltoi gslein ho.it
Total, Average & Marginal
Product Curves
VMPLMAX -yMP=W
o Increasing marginal returns:
Range of input usage over
• which marginal product
to:* increases
.

ÑrgÑÑ\ •
o Decreasing (diminishing)
i. marginal returns: Range of
tanytiid-d.AM
hot
input usage over which

gd-i.saisbi.org
marginal product declines.
• o Negative marginal returns:
tairgsanhi.mg Range of input usage over

bienaengtañg which marginal product is

negative.

8-8
 Phases of
Marginal Returns
As the usage of an input increases, marginal product
initially increases (increasing marginal returns), then
begins to decline (decreasing marginal returns), and
eventually becomes negative (negative marginal
returns).
9
 The Role of the Manager in the taidieñinño
Production Process dimishinyrnarginalvelnrnséxuat
hair
1. To ensure that the firm
operates on the production
function
2. To ensure that the firm uses
the correct level of inputs.
○ value marginal product: The chithéhieñ
value of the output produced
by the last unit of an input.
MPLMAXI^MUM •
• APma×
!"#! = # % "#! MPL=w
!"#" = # % "#" -0T

8-10
 Profit-Maximizing
Input Usage
To maximize profits, a manager should use inputs at levels at
which the marginal benefit equals the marginal cost. More
specifically, when the cost of each additional unit of labor is w,
the manager should continue to employ labor up to the point
where VMPL = w in the range of diminishing marginal product

11
 cost
A cost
variable
Short Run Production Costs

◎ Total variable cost (TVC) minimize

○ Total amount paid for variable inputs
the
○ Increases as output increases
cost
◎ Total fixed cost (TFC)
production
○ Total amount paid for fixed inputs
○ Does not vary with output
of
◎ Total cost (TC)
○ TC = TVC + TFC
8-12
 Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable Total Cost

(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,00 15,000
0
14,000 20,000
400 6,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

8-13
Total Cost Curves

f.¥
¥
1¥
Fc I

8-14
 Average Costs
• Average variable cost ( AVC )
TVC
AVC =
Q
• Average fixed cost ( AFC )
TFC
AFC =
Q
• Average total cost ( ATC )
TC
ATC = = AVC + AFC
Q
8-15
 Short Run Marginal Cost

◎ Short run marginal cost (SMC) measures

rate of change in total cost (TC) as output
varies
I DTC DTVC achangeinfc
SMC = =
because Fcdoes DQ DQ "

not change achangeintvc

8-16
 Average & Marginal Cost Schedules

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/ (AVC=TVC/Q) (ATC=TC/Q= (SMC=DTC/DQ)
Q) AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

8-17
Average & Marginal Cost Curves

8-18
 Short Run Average & Marginal
Cost Curves
www.#H
µ > oiiémhi "
Haiti breakeven
→ ,
point

breakeven
Point y
qi< 7-
shutdown point
to →
•

µéjµÑdÑÑ P > Avcmin

↳ vañotangcthécoverdiio:c 8-19
 ¥Short Run Cost Curve Relations
i'
◎ AFC decreases continuously as output
increases
○ Equal to vertical distance between ATC & AVC
◎ AVC is U-shaped
○ Equals SMC at AVC’s minimum
◎ ATC is U-shaped
○ Equals SMC at ATC’s minimum

8-20
 Short Run Cost Curve Relations

◎ SMC is U-shaped
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are
falling
○ Lies above AVC & ATC when AVC & ATC are
rising

8-21
 inverse relationship
Relations Between Short-Run Costs & Production

8-22
Relations Between Short-Run Costs & Production
inseam
◎ In the case of a single variable input, short-run
costs are related to the production function by
two relations
w w
AVC = and SMC =
A
MP MP

Where w is the price of the variable input

8-23
 Short-Run Production & Cost Relations

gAPreachm.axinmmtg@AVCseaohitsminiumu1neayg.y
" " ""

yup increase
①
* "

decrease
slue

, ,,µ , , ,,

g 8-24
 Relations Between Short-Run Costs
& Production

inverse
◎ When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
relations
◎ When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
◎ When marginal product = average product at maximum AP,
marginal cost = average variable cost at minimum AVC

8-25
 Summary of Short-Run Empirical
Production Functions
7

'
Short-run cubic
otanghuoigxnuñg production equations

MPEGAL-LBakenjyY.in?otai gidm--J
:O Total product Q = AL3 + BL2
otgohainlup
Average product of labor AP = AL2 + BL
I Marginal product of labor MP = 3 AL2 + 2 BL
Diminishing marginal
returns
begin at Lm = -
B
L=¥n
3A
Restrictions on
A < 0 and B > 0
parameters
10-
 otaidiein " Summary of Short-Run Empirical
breakeven Point
aiaohiphitrongnganhqn
oganioiqram
→ ATC
Cost Functions
spec intersect

A Short-run cubic
cost equations
ATC

shutdown point
AFC
Arc Total variable cost TVC = aQ + bQ 2 + cQ 3 SMC intersect
- Click to add text
Average variable cost AVC = a + bQ + cQ 2 AVC
curb
U-shaped betweenMarginal cost SMC = a + 2bQ + 3cQ 2
priacshutdoun
intersection Average variable cost
Qm = -
b
reaches minimum at point
2c
SMCIATC Restrictions on
shutdown

parameters
a > 0, b < 0, c > 0 and wait
at its
lowest Point BAIOUOIKIVÉVAIIAÉ 'HÑ 10-
 nuic.mtag/ieBwiMsa'aftonixuoidahoñsai
rla.i njsrp'luaMP=AP-Tmh-asx

.gr/VHPl-WTtie Kho iMPL=OVMPL:valuehoc. ase

↳ thielbuoinglaodin

Sunk cost
A cost that is forever lost
after it has been paid.
and
mastery

marginal product moiyoto

28
 Fixed and Sunk Costs
because
yes Considering this illustration problem: Fixed cost
→
◎ ACME Coal paid $5,000 to lease a railcar from the Reading
us:÷÷a•+ Railroad. Under the terms of the lease,0 $1,000 of this payment is
refundable if the railcar is returned within two days of signing the
41000 lease. 2 days 5000
after
sunk cost
=

1. Upon signing the lease and paying $5,000, how large are ACME’s

f- fixed costs? Its sunk costs? sunkcostinthefirstddays-4.NO

2. One day after signing the lease, ACME realizes that it has no use for
the railcar. A farmer has a bumper crop of corn and has offered to
sublease the railcar from ACME at a price of $4,500. Should ACME
accept the farmer’s offer?
If ACME not accept + lose 4000
thy loose 500 8-29
 labor -1 product → cost

A
firm estimate it marginal cost sMC=125-0it8Q4b
Fixcost

Price =
= 3000

100
/ Continue to operate ?

profit hayI → ATC so

AVC-12-b-939.at#-bQf santry
, go $
during diein
shutdown point Arc min# Q=¥ =

that what
'

AVC min = 9965 LP continue to operate

so sants voi p

from the
function of SMC '
SMC = 010045 Q -0,78 Q -1129
'
= 3C Q + LBQ + a

3C = 90045 0=90015
{ {
→

2b = -0,78 → b= -939

a = 125 a
= 125
P > Arc nun Hip
→ AVC at BQ + COY
tnsaisxuaii
=

= 125 - 93901 -10,0015012

Qm :
¥ =
130
, Armin = 99,65L 100 =P should

operate
 Arc = 125-939 Q +
0,0015 Q2
NC =12501-939012+0,0015013
TC : Nct FC 125 Q -9390140,0015013 -13000
=

ATC =
1¥ = 125 Q -

0,39A +0,001592 -1300¥

ATC SMC ATC Q ATC min zP ?

=
min :

*
oiiotieñivñmqhaiacailoai chiphis R .

AVC

( AF
SR
C) u shaped

is :
curve
Exercise 1

8-30
Exercise 1

a. What are the estimated total, average, and marginal product

functions?
b. Are the parameters of the correct sign, and are they significant
at the 1 percent level?
c. At what level of labor usage is average product at its maximum?
Assume that the wage rate for labor (w) is $200.
d. What is output when average product is at its maximum?

8-31
Exercise 2

8-32
Exercise 2

a. Do the parameter estimates have the correct signs? Are they

statistically significant at the 5 percent level of significance?
b. b. At what level of output do you estimate average variable cost
reaches its minimum value?
c. What is the estimated marginal cost curve?
d. What is the estimated marginal cost when output is 700 units?
e. What is the estimated average variable cost curve?
f. What is the estimated average variable cost when output is 700
units?

8-33
2.
Production and Cost
in the Long Run

34
Typical Isoquants

to produce
B certain
level
of
Ham C
output

9-35
 Marginal Rate of Technical Substitution

◎ The MRTS is the slope of an isoquant & measures the

rate at which the two inputs can be substituted for one
another while maintaining a constant level of output
DK
MRTS = -
DL
The minus sign is added to make MRTS a positive
number since DK DL, the slope of the isoquant, is
negative

9-36
 Marginal Rate of Technical Substitution

◎ The MRTS can also be expressed as the ratio of two

marginal products:
MPL
MRTS =
MPK
As labor is substituted for capital, MPL declines &
MPK rises causing MRTS to diminish

DK MPL
MRTS = - =
DL MPK
9-37
 Isocost Curves

• Show various combinations of inputs that

may be purchased for given level of
expenditure ( C ) at given input prices ( w, r )
C w
K= - L
r r
• Slope of an isocost curve is the negative
of the input price ratio ( - w r )
• K -intercept is C r
○ Represents amount of capital that may be purchased if zero labor is
purchased
9-38
Isocost Curves

more
capital
hire I
labor
fire

9-39
 Optimal Input Combination to Minimize
Cost for Given Output
A Bdoanhngheiép
so South AIB thñphom
☒ Ñn Briain 'd isocost roiuhiphithaphoir
tip "
trepluyñi
isoquant gmñisoquant

/
→
⑧ vñiso cost

giaodiein I vchiphisxthapinhai
→ chiphisañxnaii
9-40
 -
Optimal Combination of Inputs

◎ Minimize total cost of producing Q by choosing the input

combination on the isoquant for which Q is just tangent to
isocost curve
◎ Two slopes are equal in equilibrium
◎ Implies marginal product per dollar spent on last unit of
each input is the same
toiiiuhoa MPL w MPL MPK
'
= or =
ohiphisanxnat MPK r w r
9-41
 DEMONSTRATION PROBLEM

Terry’s Lawn Service rents°five small push mowers and two

large riding mowers to cut the lawns of neighborhood
households. The marginal product of a small push mower is r 3
-

lawns per day, and the marginal product of a large riding

mower is 6 lawns per'day. The rental price of a small push

O
-

mower is $10 per day, whereas the rental price of a large riding
mower is $25 per day. Is Terry’s Lawn Service utilizing small
push mowers and large riding mowers in a cost-minimizing
manner? MP=3

8-42
 MP :b MP
push push
=L
MP :b MP
riding riding

Rental price
✓
push / hiding = =
}

MPmsh-t-I
Mp
riding
I . l a ?-g not
utilizing
Pn : rental
price of small push mower → P, = 10

Pq .
rental price of large riding mower P2 -15

MPH
Mp÷=% Mpp÷-+MpP÷ not minimizing cost

Mpz=6
Mf÷=¥
Are firm should increase using small push mower chototkhi
decrease Nat = plan
using large riding mover

doing it-doini.laodto.mg#MPcoingmga-ycaiytoingleri
 Long-Run Costs

◎ Long-run total cost (LTC) for a given level

of output is given by:
LTC = wL* + rK*
◎ Where00
w & r are prices of labor & capital, respectively
-

9-43
 Long-Run Costs
◎ Long-run average cost (LAC) measures the cost per unit
of output when production can be adjusted so that the
optimal amount of each input is employed
○ LAC is U-shaped
○ Falling LAC indicates economies of scale
○ Rising LAC indicates diseconomies of scale
LTC
LAC =
Q

9-44
 Long-Run Costs
◎ Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes along
expansion path
○ LMC is U-shaped
○ LMC lies below LAC when LAC is falling
○ LMC lies above LAC when LAC is rising
○ LMC = LAC at the minimum value of LAC

DLTC
LMC =
DQ
9-45
 shutdown
p(LACmin= →
tronydaihqnno.ichiphidtiila-chiphibi.in'd-of
Long-Run Average & Marginal Cost
a-

chicken ←

shutdown half
00
large firms
I
orthoi scale
economies of
of enjoy to "

economies ?:# m¥%I¥T

sxcañgnhfsfigp
on
produce cost
lower price ← reduce producing 9-46
 INSIDE BUSINESS
In industries with economies of scale, firms that produce greater levels of output produce at lower
average costs and thus gain a potential competitive advantage over rivals. Recently, two
international businesses pursued such strategies to enhance their bottom line.
Japan’s Matsushita Plasma Display Panel Company, Ltd., invested $835 million to build the world’s
largest plant for producing plasma display panels. The factory—a joint venture between Panasonic
and Toray Industries—had the capacity to produce 250,000 panels per month by the late 2000s.
This strategy was implemented in response to rising global demand for plasma display panels, and
a desire on the part of the company to gain a competitive advantage over rivals in this increasingly
competitive industry.
An automaker in India—Maruti Udyog Ltd.—produced tangible evidence that economies of scale
are important in business decisions. It enjoyed a 271 percent increase in net profits in the mid-
2000s, thanks to its ability to exploit these economies. The increase was spawned by a 30 percent
increase in sales volume that permitted the firm to spread its sizable fixed costs over greater
output. Importantly, the company’s reduction in average costs due to economies of scale was
more than enough to offset the higher costs stemming from increases in the price of steel.
SOURCES: “Matsushita Plans Big Expansion of PDP Manufacturing,” IDG News Service, May 19, 2004; “MUL Gains from Cost-Saving Measures,” Sify India, May
18, 2004.
47
 “
Part 2.
The organization of a firm

48
phai make sure input lair output

↳ importfrom materials

countries
foreign
49
 OVERVIEW
I. Methods of Procuring Inputs
○ Spot Exchange
○ Contracts
○ Vertical Integration
II. Optimal Procurement Input
III. Principal-Agent Problem
○ Owners-Managers
○ Managers-Workers

50
Learning objectives
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how each can
lead to costly bargaining, underinvestment, and/or a “hold-up
problem.”
3. Explain the optimal manner of procuring different types of inputs.
4. Describe the principal–agent problem as it relates to owners and
managers.
5. Discuss three forces that owners can use to discipline managers.
6. Describe the principal–agent problem as it relates to managers and
workers.
7. Discuss four tools the manager can use to mitigate incentive problems in
8. the workplace. 51
1.
METHODS OF
PROCURING INPUTS
1. Spot exchange
2. Contract
3. Vertical integration
52
 METHODS OF PROCURING INPUTS

Consider the manager of a car rental company. One input

needed to produce output (rental cars) is automobile
servicing (tune-ups, oil changes, lube jobs, and the like). The
manager has three options:
1. Simply take the cars to a firm that services automobiles
and pay the market price for the services
2. Sign a contract with a firm that services automobiles
3. Create within the firm a division that services
automobiles
53
 METHODS OF PROCURING INPUTS

◎ Spot exchange: An informal relationship between a

buyer and seller in which neither party is obligated to
adhere to specific terms for 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.
◎ Vertical integration: A situation where a firm produces
the inputs required to make its final product.

54
 SPOT EXCHANGE (AT ARM’S LENGTH )
◎ Definition: An informal relationship between a buyer
and seller in which neither party is obligated to adhere
to specific terms for exchange.
○ Occurs when autonomous parties exchange goods or services
with no explicit or implicit agreement that the relationship will
continue into the future.
◎ Examples: Purchasing at Coop Mart, staying at New World
hotel for a night.
◎ Advantage: the firm gets to specialize in doing what it
does best

55
 CONTRACTS

◎ Definition: A contract is a legal agreement which defines the

conditions of an exchange or series of exchanges.
○ A formal relationship between a buyer and seller that obligates the buyer
and seller to exchange at terms specified in a legal document
◎ Examples: Bank loan, futures contract, marriage, etc.
◎ Advantage: purchase “nonstandard” inputs
◎ Disadvantage: costly to write; it takes time, and often legal fee,
extremely difficult to cover all the contingencies that could occur
in the future

56
 VERTICAL INTEGRATION (VI)

Definition: it is the situation where a firm shuns other

suppliers and chooses to produce an input internally.
◎ It alters control structures. Hidden information and hidden action
problems are reduced.
◎ Repeated interactions improve trust and coordination
◎ The integrated firm has a common set of goals.
◎ But remember the problems with making
Advantage: no longer has to rely on other firms
Disadvantage: loses the gains in specialization, has to
manage the production of inputs and final product
→bureaucratic costs associated with a larger organization.
57
 PRACTICE

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.

58
 TRANSACTION COSTS

◎ Definition: Transactions costs are costs associated with

acquiring an input that are in excess of the amount paid to
the input supplier (Coase, 1937).
◎ Obvious examples: Insurance, freight, damage, own time.
◎ Other important examples: cost of searching for a supplier
willing to sell a specific input, negotiations costs incl.
opportunity cost of time, legal costs, costs of maintaining
assets required to engage in the transactions.

59
 TRANSACTION COSTS

◎ Many transaction costs are obvious.

○ Ex: input supplier charges a price of $10 per unit but
requires you to furnish your own trucks and drivers to
pick up the input → transaction costs : the cost of the
trucks and the personnel needed to “deliver” the input
to your plant.
◎ Some important transaction costs are less obvious →
distinguish b/w transaction costs : specific to a particular
trading or general in nature → specialized investment.

60
 SPECIALIZED INVESTMENT

◎ Definition: A specialized investment (SI) is an expenditure that is

made to allow two parties to make exchanges, but has less value in
alternative uses.
→ Examples: to ascertain the quality of chips, Apple spend $100 on a machine that tests the
chips’ quality:
○ If the machine is useful only for testing chips from TSM → SI.
○ If the machine can be resold at its purchase price or used to test the quality of
bolts produced by Intel Corp→ not a SI
→ Examples: Insuring assets (life or crops) when taking out a loan, building trust with a
supplier/customer, quality control investments required to access international markets
(food, toys, etc.).
◎ Definition: A relationship-specific exchange is one that occurs when
both parties to the exchange have made specialized investments.
These investments are called relationship-specific investments (RSIs).
61
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

1. Site specificity
2. Physical asset specificity
3. Human asset
4. Dedication

62
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

=
◎ Site specificity: Here, assets are situated side-by-side.
○ Examples: Coal mines and power plants, grain elevators and
rail-spurs, processes in steel or wine production

◎ Physical asset specificity: Here, the physical/

engineering/chemical properties of the asset are tailored
to a given set of transactions.
○ Examples: Dyes and molds, some genetically modified

↳
organisms, software products
d- aiiteinhamaymoiidaiyduyeiisais.ae
aimoi

63
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Human asset specificity: Here, the SI is human in nature.

○ Examples: Skill acquisitions, building trust
◎ Dedicated asset: is one that would be a complete write-
for.Y foff if the transactions in question were cancelled.
book ↳ spiotdotñuaotangluirisaiusmaiiroi
physical There are other types of specificities, and some investments
assets may express multiple forms I
dtiavoionhungohipkinaiy
hwmancapitalkinoingd-ai.biet.dk/aid-in.hnin M&A .
vertical hay
integration 64
 USEFULNESS OF SIs

◎ SIs generally promote economic efficiency (increase the

welfare of society) in that they identify collaborations
between firms that reduce the cost of producing the
same amount of goods or increase the amount of goods
produced by the same level of resources or do a bit of
both (supply/demand graphs).
◎ They are probably good for the firms in question because
the firms would likely not make the investment
otherwise.
◎ Problems may arise because SIs create vulnerability.
65
 ñqw•i
IMPLICATION OF SI
d-
V98
◎ Specialized investments increase transaction costs
a-
mix because they lead to
(1) costly bargaining: no other supplier capable of providing the
desired input at a moment’s notice → no “market price” for the
input → bargaining process costly
(2) underinvestment: the level of the specialized investment often
is lower than the optimal level.
(3) opportunism: When a SI existed, buyer/seller attempt to
capitalize on the “sunk” nature of the investment by engaging in
opportunism
timeto
bargain time consuming
-

spend t
process
is

66
 IMPLICATION OF SI

(3) opportunism:
→ The “hold-up problem”: Once a firm makes a
specialized investment, the other party may attempt to
“rob” it of its investment by taking advantage of the
I investment’s sunk nature.
→ This behavior make firms reluctant to engage in
incurred "
relationship-specific investments in the first place
unless they can structure contracts to mitigate the hold-

qftitiémtra
up problem.
theism
cost
µ,
! chattering
sunk cost 67
¥
-0¥
§
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OPTIMAL INPUT
PROCUREMENT
When to use each form of input
procurement?

68
 OPTIMAL INPUT PROCUREMENT

Price fluctuation

(
Spot exchange
Burger King, a fast-food outlet, sells approximately 8,000 quarter-pound
hamburgers in a given week. To meet that demand, Burger King needs
2,000 pounds of ground beef delivered to its premises every Monday
morning by 8:00 AM sharp.
1. As the manager of a Burger King franchise, what problems would
you anticipate if you acquired ground beef using spot exchange?
2. As the manager of a firm that sells ground beef, what problems
would you anticipate if you were to supply meat to Burger King
through spot exchange?
trongsnihc 69
 SPOT EXCHANGE

◎ Used if there are no transaction costs and there are many

buyers and sellers in the input market
◎ Price is determined by the market price (intersection of
the supply and demand curves)
◎ Easily to change to suppliers that offer lower prices
◎ Disadvantages: result in high transaction costs due to
opportunism, bargaining costs, and underinvestment
when input requires substantial specialized investments

70
 CONTRACTS

◎ Overcome hold-up problem and the need to bargain

over price each time the input is to be purchased
◎ Can specify prices of the input before the parties make
specialized investments
◎ Reduces the incentive for either the buyer or the seller to
skimp on the specialized investments required for the
exchange
◎ How long should the contract last?

71
 CONTRACT LENGTH

◎ “Optimal” contract length: trade-off between the

marginal costs and marginal benefits of extending the
length of a contract.
◎ MC increases as contracts become longer
○ Contracts of long duration are more difficult to write because it
is harder to specify all contingencies, e.g., oil price rise, new
technology, etc; the less flexibility the firm has in choosing an
input supplier
◎ MB (avoided transaction costs of opportunism and
bargaining) vary with the length of the contract
○ For simplicity we can draw a flat MB curve
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OPTIMAL CONTRACT LENGTH

73
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

74
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

75
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

76
 VERTICAL INTEGRATION

◎ Produce the input internally. Utilized when:

○ SIs generate transaction costs (due to opportunism, bargaining costs,
or underinvestment)
○ Product is extremely complex
○ The economic environment is plagued by uncertainty specialization
◎ Advantage: mitigate transaction costs Cannot enjoy of
◎ Disadvantages: → the advantageanymore
○ Managers must replace the discipline of the market with an internal
regulatory mechanism
○ The firm must bear the cost of setting up production facilities →firm no
longer specializes in doing what it does best
◎ VI should be undertaken only when spot exchange or contracts
have failed.
77
 OPTIMAL INPUT PROCUREMENT

Depend on the extent to which there is relationship-

specific exchange.

78
 EXAMPLE: GENERAL MOTOR AND FISHER BODY
sdiongmofie .

patron ◎ Early 20th century: specialized investments

'
.

Nian were relatively unimportant → GM bought

Airi the bodies for its cars using spot exchange
dong ◎ Closed metal bodies for car manufacturing
→ high degree of physical-asset specificity
→ GM and Fisher Body signed a 10-year
contract
◎ Parties to engage in opportunism → GM
vertically integrated by purchasing Fisher
Body

ho.owiadluoiiÑggheilmi nhiinggixayratrongho.in
d- fisher body loidu.mg thot co
79
 METHODS OF PROCURING INPUTS

◎ Spot Exchange
○ When the buyer and seller of an input meet,
exchange, and then go their separate ways.
◎ Contracts
○ A legal document that creates an extended
relationship between a buyer and a seller
◎ Vertical Integration
○ When a firm shuns other suppliers and chooses to
produce an input internally

80
 KEY FEATURES

◎ Spot Exchange
○ Specialization, avoids contracting costs, avoids costs of vertical
integration.
○ Possible “hold-up problem.”
◎ Contracts
○ Specialization, reduces opportunism, avoids skimping on
specialized investments
○ Costly in complex environments
◎ Vertical Integration
○ Reduces opportunism, avoids contracting costs
○ Lost specialization and may increase organizational costs
81
 THE PRINCIPAL-AGENT PROBLEM

◎ Occurs when the principal cannot observe the effort of the agent.
○ Example: Shareholders (principal) cannot observe the effort of the
manager (agent).
◎ The Problem: Principal cannot determine whether a bad outcome
was the result of the agent’s low effort or due to bad luck
◎ Manager’s must recognize the existence of the principal-agent
problem and devise plans to align the interests of workers with that
of the firm
◎ Shareholders must create plans to align the interest of the manager
with those of the shareholders.

82
83
Manager receive 10 percent of profits

84
 SOLVING THE PROBLEM BETWEEN OWNERS AND
MANAGERS

◎ Internal incentives
○ Incentive contracts
○ Stock options, year-end bonuses
◎ External incentives
○ Personal reputation.
○ Potential for takeover.

85
 SOLVING THE PROBLEM BETWEEN WORKERS AND
MANAGERS

◎ 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.
◎ Piece rates: depend on the output produced
◎ Time clocks and spot checks
→ ghii.eu quoi

86
 CONCLUSION

◎ The optimal method for acquiring inputs

depends on the nature of the transactions costs
and specialized nature of the inputs being
procured.
◎ To overcome the principal-agent problem,
principals must devise plans to align the agents’
interests with the principals.

87
Google Buys Motorola Mobility to Vertically Integrate In a bold move,
Google purchased Motorola Mobility—the recently spun-off cellular
arm of Motorola—for $12.5 billion. This move marks an attempt by
Google to vertically integrate into the smartphone hardware market.
Industry experts note that the purchase will allow Google to build
prototypes and advanced hardware devices that will help to point its
software business partners in the direction Google wants to go.
Google is banking on the increased coordination between its
software and Motorola’s hardware and the reduction in risks
associated with vertical integration outweighing the costs.
If you were a decision maker at Google, would you have
recommended vertical integration?

88
Thank you for
your listening!
Any questions?

You can find me at:

an.vohoangkim16@gmail.com
89