FINC304

Managerial Economics

Session 7: Organisation of the Firm

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS

Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Session Overview
• In session 6, we selected the right combination of inputs that
firms have to use in their production in order to maximize
profit. However, if we make this optimal selection of inputs
and yet we are not able to procure the inputs in the right way,
we will not be able to maximize our profit in the way we want
to. Again, even if we select the inputs in the right proportion
and we are not able to drive labour to put in his best effort,
we will still not be able to maximize profit. Therefore in this
session, we look at how to procure inputs in the right way and
drive labour to put in his best effort.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2

 Session Outline
The key topics to be covered in the session are as follows:
• How to Procure Inputs
• How to drive Labour to put in his best effort

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3

 Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4

 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.
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5
 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.
• Lost specialization and may increase organizational costs

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6

 Transaction Costs: The Key
Consideration
• 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.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7

 Importance of Specialised Investment

• Investments made to allow two parties to exchange but has little or no value
outside of the exchange relationship

• Types of specialized investments:

• Site specificity, physical-asset specificity, dedicated assets, human capital

• Specialized investments are typically procured under relationship-

specific exchange

• Lead to higher transaction costs

• Costly bargaining
Underinvestment
• Opportunism and the hold-up problem

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 8

 Or an1zat1on o f the F1rm Procunng Inputs
g Gett1ng Max11num from Inputs

Optimal Input Procurement

Substantial
specialized
investments
relative to
contracting costs?
costs of integration?

No

Vertical
Integration
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 9
Dr P Asum1ng, D r A Gyeke-Dako and D r H Managenal Econom1cs Lecture four
 Principal-Agent Problem: The Setting

In many large firms/corporations, ownership is separated from

management

Owners employs managers to perform a task on their behalf

day-to-day management firm

Owners do not perfectly observation what managers do

whether they work hard, take too much risk etc

If managers do not work hard, it affects the profits of the owners

How can owners ensure managers work hard?

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10

 Solving the Owners –Managers
Problem
• Broad solution: shareholders must create plans to
align the interest of the manager with those of the
shareholders
• Incentive contracts
• Stock options
• Other bonuses tied to profit

• External incentives
• reputation of managers
Threat of takeovers

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 11

 Solving the Owners –Managers
Problem
• Manager hires worker to perform a task

• Manager does not perfectly observe effort/work of

worker
• It will be costly to observe workers round the clock

• Worker has incentive to shirk

• Hard work is costly for the worker

• Worker’s effort affect performance of firm

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 12
 Solving the Owners –Managers
Problem
• Profit sharing
• Revenue sharing
• Piece rates
• Time clocks and spot checks

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 13