Lecture 10
Economic Theory of the Firm
There are two views of the firm:
1. Neoclassical (traditional) theory:
 Firm is a calculating entity, that makes
decisions, buys inputs, making output, and
selling for profit for loss
2. Property rights theory:
 Firm is a collection of contracts between owners
of resources, who wish to combine portions of
their resources, for some period, for some
purpose
Traditional Theory of the Firm
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Traditionally, the firm — headed by the entrepreneur
or manager — makes decisions:
– What to produce?
– When and how to produce it?
– How much to produce?
– What is its price?
The firm is seen as having a production function:
– Relates inputs and outputs — like a recipe
 q = q (x,y,z)
 q is output
 x, y, z are inputs
– The exact form depends on technology, etc.
A production function
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A production function is often a mechanical view of
production:
– 1 shovel of cement
– 3 shovels of sand
– 5 shovels of stone
– 4 liters of water
– Use labor to mix cement, sand, and stone for 1 minute
– Add more water to get right texture
– Use labor to mix ingredients for 2 minutes
– Output: 12 liters of wet concrete
Most of this is engineering. The role of economics is
limited to the importance of price, substitutes, etc.
Important concepts, but not difficult to grasp.
Property Rights Theory:
Firms and Markets
The tradeoff:
– Market is informationally efficient
– The firm is contractually efficient
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The balance between these two
determines the methods of production
chosen by an entrepreneur or manager
What Kind of Organizational
Form to Choose?
A key role of managers is to procure inputs in
the least cost manner.
If not accomplished, costs will be higher than
needed and the firm will lose profits and
perhaps go bankrupt.
Basic Question: To achieve greater efficiency,
does a manager procure inputs from the
market or procure inputs within the firm?
How to obtain needed inputs?
Consider possible stages of production:
Obtaining raw materials
Obtaining finished parts
Assembly
Transportation services
Storage
Wholesaling
Retailing
How to obtain needed inputs?
General services needed by a firm:
Accounting
Finance (including credit service)
Human Resources
Legal Services
Marketing (advertising, etc.)
Janitorial Service
Who is to provide such services?
Who provides needed
services and materials?
Should the firm produce within the
organization or buy from the outside?
 There is no one answer—many
conditions will determine outcome.
 Think of the great range of options:
Spot markets → Long Term Contracts →
Vertical Integration (produce in house)
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Inputs Can Be More Costly
than Necessary
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Study of a ship building firm showed transaction
costs were 14% of the total cost of construction.
Wrong decisions about how to obtain inputs are
costly.
Some internal inputs that could have been bought
for less from outside increased cost as much as
70%.
External purchases that could have been done inhouse for less increased cost as much as 300%.
Methods of Obtaining Inputs
1. Spot market or spot exchange—
Buyers and sellers exchange, but might not
deal again.
Benefits: deal with specialized sellers, who often
have economies of scale not possible within
the firm, and usually low transaction costs.
The provider is not integrated into the firm.
Possible problems: Exploitation by seller who
knows we are ignorant; inconsistent quality;
lack of internal coordination. Information leaks
to competitors.
Products involved are usually generic.
Methods of Obtaining Inputs
2. Contracts—
Legally based extended relationship
between buyer and seller.
Benefits: Specialization; ability to terminate
sellers who do not perform; reduction in
exploitation compared to spot markets.
Problems: Costly in complex environments;
difficult to specify quality exactly and to
measure quality; unforeseen problems
including liability issues.
Contracting Complexity: Ford
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Ford used annual bidding competition to
achieve low cost suppliers for auto parts
($7 billion a year).
Problems: high administrative cost,
bankruptcy by suppliers (Delphi), quality
control uneven
Solution: multi-year contracts with fewer
suppliers (down from 2,500 to 1,000);
closer working relationship; estimated
savings of 10% per year.
Many Forms of Contracts
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Services (Deere and Ryder Trucks; UPS
and Toshiba warranty laptop repairs; UPS
and Jockey; Japanese call centers in Dalien)
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Joint Ventures (foreign firms in China)
Leases (office buildings)
Franchises (McDonalds, car dealers)
Strategic Alliances (Merck & Astra)
Politics May Help Force Form
McDonalds in Japan was run by politically wellconnected Japanese company (JMcD).
Toys “R” Us (Toys) wanted to enter Japan but
bureaucrats stopped it.
Alliance between JMcD and Toys: took care of
politics and found natural benefits—JMcD knew
the Japan real estate and customer market
well. Every Toys store had JMcD in it. JMcD as
profit partner had strong incentive to help Toys
be successful.
Methods of Obtaining Inputs
3. Vertical Integration—
(Non-market relations)
When a firm chooses to produce an input
internally rather than contract with outsiders.
Benefits: Reduced opportunistic behavior by
outsiders and fewer contracting costs.
Problems: Lost specialization, locked into certain
method of production, and increased
organizational (managerial) costs.
Inputs are usually highly specialized.
When Is Vertical Integration
More Likely to Be Necessary?
To protect brand name. Examples: Sony, Prada
When there are specific assets or high sunk
costs. Examples: pipeline; GM-Fisher; refinery.
[Consider: Is it risky for an employee to become
asset specific to a particular employer?]
When economies of scale changes—Coke and
Pepsi now own most bottling plants and
control national marketing strategy.
When coordination critical: stages of health care.
Multiple Forms May Exist
About 20% of gasoline in U.S. is sold at stations
owned by refiners (this share growing). Other
80% of gasoline sold by other companies.
Why not all one way or the other?
Refiners control retail price at their stations, but
cannot control independents—can prevent price
gouging by independents.
Company owned stores tend to be huge stations
not offering repair services or other specialized
services done better by independents who will
work to protect their personal reputation.
Forward or Backward Integration
Forward—A company that owns a coal mine
builds a power plant to generate electricity.
Backward—An electric company buys a coal mine
to guarantee supply.
When the two are close to each other—usually
integrate into one firm. Specific investments—
boiler design tied to coal type.
When utility not near coal mine; long term
contracts with suppliers usually relied upon.
Why not short term or spot contract?
Integration in Insurance Industry
Whole life often sold through in-house sales
force. The company holds the key asset (list of
clients). To get agents to work hard the
commissions are frontloaded—big at time of
first sale.
Fire and casualty insurance usually sold through
independent brokers. The brokers hold the key
assets (list of clients). To keep them tied to
insurance company, the commissions are
backloaded—renewal commission every year.
Methods of Obtaining Inputs
Summary:
Are there specialized investments relative to
contracting costs? If no—likely to use spot
market.
If yes—is the cost of contracting high relative
to the cost of integration? If yes—vertical
integration; if no—contracts with outside
suppliers.
Think about chickens (or spinach).