Specialized Investments and Contract Length oF eh Crone ag Contracting Environment and Contract Vertical Integration + Produce inputs internally + Use when inputs require ~ a substantial spedaied investment. = generate significant transaction cost ~ complex contracting or uncertain economic environments + Advantages: ~ "Skips the middleman" = Reduces opportunism = witigates transaction costs + Disadvantages: ~ Managers must create an internal regulatory mechanism ~ Bear the cost of setting up production facies, = No longer specialized in producing ts output Optimal Procurement of Inputs Managerial Compensation and the Principal-Agent Problem + The primary obstacle is the separation of ownership and control. incipal-agent (P-A) problem: ifthe owner is not present to monitor the manager, how can she get the ‘manager to do what isin her best interest? = Owners have to incent managers since they are not present to monitor. Managers’ Compensation Mechanisms + Manager's economic trade-off = Leisure, = labor + Fixed salary Receives wage independent of labor hours an effort * Nostiongincenve te monitor ater empoyees bor hous Srastior. + hoverely impact fem perfomance + Incentive contract = Tie manager wage to firm performance ike profits). = Manager makes labor leisure choice and is accordingly compensated Incentive Contracts + Away to align owners’ interests with that of the actions of its manager. + Examples include: — Stock option — Other bonuses directly related to profits. External Incentives * Outside forces can provide manages with the incentive to maximize profits, and include: — Reputation — Takeover threat The Manager-Worker Principal-Agent Problem + The owner-manager, principal-agent problem is not unique. = Asimilar problem exists between the firm's ‘managers and the employees he or she supervises. Solutions to the Manager-Worker Principal-Agent Problem ‘Manager-worker principal-agent problem solutio — Profit sharing — Revenue sharing ~ Piece rates 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.Management's Role Methods of Procuring Inputs + Spot exchange ~ Aan informal relationship between a buyer and seller in ‘which nether party is obigated to adhere to specific terms for exchange. + contract, ~ ‘formal relationship between a buyer and seller that ‘obligates the buyer and seller to exchange at terms Specified in algal document. Produce inputs internally (vertical integration) = Asituation where a frm produces the inputs required to-make is final product. Methods of Procuring Inputs In Act + Determine whether the following transactions involve spot exchange, a contract, or vertical integration: = Gone 1 PC's legally obligated to purchase 300 computer hips each year for the new 3 years rom AML. The price palin the fst yeor 200 perch, and the pice Fes uring the second and third years bythe same percentage Bylwhich the wholesale pies index ses during those ears. ~ Gone 2 Pc purchased 300 computer chips fom a firm that Fann advertisement in the back of computer magazine = Gone 3 PC manufactures its avn motherboards nd Computer chips forts personal computers, + Answers: Clone 1 PCis using a contact = Cone 2 PC used the spot exchange. = Cone 3 PC uses verti integration 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 Types of “Hidden” Transaction Costs + Specialized investment ‘= Expenditure that must be made to allow two patties to exchange but has litle or no value in any alternative use + Relationship-specific exchange Atype of exchange that occurs when the parties toa transaction have made specialized investments Types of Specialized Investments + Types of specialized investments = Ste specty physcaaeetspecinty ~ Dediated assets Human capital Implications of Specialized Investments + Implications of specialized investments Costly bargaining ~ Underinvestment — Opportunism and the “hold-up problem” Optimal Input Procurement + How should a manager acquire inputs to minimize costs? — Depends on the extent of the relationship-specific exchange. 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 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 liked to skimp on specialized investment. — Requires decision on optimal contract length. Optimal Contract Length 5 rene