Managerial Economics & Business
Strategy
Chapter 6
The Organization of
the Firm
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Overview
I. Methods of Procuring Inputs
– Spot Exchange
– Contracts
– Vertical Integration
II. Transaction Costs
– Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
– Owners-Managers
– Managers-Workers
6-2
Procuring Inputs
 What is the optimal way to acquire the efficient
mix of inputs?
 How does the firm assure it is operating on the
cost function?
 Least cost must be applied to methods of
obtaining inputs as well as their use.
 How can the owners of a firm make sure that
workers are putting forth maximum effort?
6-3
Manager’s Role
 Procure inputs in the
least cost manner, like
point B.
 Provide incentives for
workers to put forth
effort.
 Failure to accomplish
this results in a point
like A.
 Achieving points like B
managers must
– Use all inputs efficiently.
– Acquire inputs by the
least costly method.
Costs
C(Q)
A
$100
80
B
Q
0
10
6-4
Methods of Procuring Inputs
 Spot Exchange
– When the buyer and seller of an input meet,
exchange, and then go their separate ways.
– Buyer and sellers are anonymous.
– No legal relationship between the buyer and
seller.
– Advantage – specialization
– Used when inputs are standardized and there
exist many potential suppliers.
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Methods of Procuring Inputs
 Contracts
– A legal document that creates an extended
relationship between a buyer and a seller over a
specific period of time.
– Allows specialization for both sides involved in a
contract.
– Works well when contract specification is easy.
– Disadvantage – costly to write and cover all
contingencies.
– In complex environments contracts will be
incomplete
6-6
Methods of Procuring Inputs
 Vertical Integration
– When a firm shuns other suppliers and chooses to
produce an input internally.
– Loses gains of specialization
– Firm has to manage both inputs and output.
– Advantage – no longer reliant on others for inputs
– Smart plant - JIT
– River Rouge - VI
6-7
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.
6-8
Transaction Costs
 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.
6-9
Transaction Costs
 Specialized investment – expenditure that
allows exchange but has little or no alternative
use.
 Generally specialized investments are sunk
costs.
 Relationship specific exchange – one or both
parties have made a specialized investment.
 Boeing /Airbus – Rolls Royce – General Electric
– Pratt & Whitney
6-10
Specialized Investments
 Types of specialized investments:
– Site specificity – locating physical plants in close
proximity.
– Coal fired electricity generators and mines;
– trans-shipment facilities close to ports;
– auto parts manufacturers and auto assembly plants.
– Physical-asset specificity – capital equipment
needed to produce an input needed by a specific
buyer cannot be used to produce an input for
another buyer.
– Automobile headlamps
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Specialized Investments
– Dedicated assets – investments made to enable
exchange with a specific buyer.
– Occurs many times in government procurement.
– Human capital – skills non-transferable to other
uses.
– Government procurement again is a good example.
6-12
Specialized Investments
 Lead to higher transaction costs
– Costly bargaining – implies only a few parties are
prepared for a trading relationship.
– No market price for the input.
– Both sides negotiate a price.
– Parties may engage in strategic behavior.
– Underinvestment – less interest in quality as the
relationship may be short term.
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Specialized Investments
 Opportunism and the hold-up problem – attempting to
take advantage of the firm making a specialized
investment by taking advantage of the investment’s sunk
nature.
 Makes firms reluctant to engage in relationshipspecific investments unless contracts can be structured
to mitigate this problem.
 If both parties are required to make specialized
investments both may engage in opportunism.
 Higher transactions costs to avoid this scenario.
6-14
Spot Exchange
 Many buyers and sellers
 Few transactions costs
 Opportunism may occur if specialized
investments are part of the production
process.
 May need to bargain each time an input is
purchased.
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Contracts
 Requires up-front expenditures
 Input prices can be specified before specialized
investments are made.
 Longer term commitment allows both buyer and seller
to invest in quality specialized investments.
 Where the gains from opportunism are large, contracts
are needed.
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Contracts
 How long should a contract last?
 Depends on MC and MB of extending the
contract.
 MC of extending contract length increase as
contracts become longer because of the greater
array of possible contingencies.
 Economies are dynamic; business conditions
change.
 MC of contract length is upward sloping.
6-17
Contracts
 MB of extending a contract is the Transactions Costs
avoided including opportunism and bargaining.
 Optimal contract length increases when level of
specialized investment required to facilitate an
exchange increases.
 As inputs become more standardized and economic
environment more certain, MC of writing longer
contracts decreases leading to longer contracts and vice
versa.
6-18
Specialized Investments
and Contract Length
$
MC
MB1
Due to greater need for
specialized investments
MB0
Longer Contract
0
L0
L1
Contract
Length
6-19
Specialized Investments
and Contract Length
$
More complex
contracting
environment
MC2
MC0
MB0
Shorter Contract
0
L2
L0
Contract
Length
6-20
Specialized Investments
and Contract Length
$
MC0
MC1
Less complex
contracting
environment
MB0
Longer Contract
0
L0
L0
Contract
Length
6-21
Vertical Integration
 Benefits:
 Ideal when specialized investments generate
transactions costs
 Or the product is very complex
 Or the economic environment is plagued by uncertainty
 Firm moves up the production stream and produces
increasingly basic inputs.
 Firm avoids the middleman.
 Reduces opportunism
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Vertical Integration
 Disadvantages:
 Market discipline is replaced by internal regulatory
mechanism.
 Firm no longer specializes in what it does best.
 Vertical integration should be viewed as a last resort
only when spot exchange or contracts are not suitable or
have failed.
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Optimal Input Procurement
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
6-24
The Principal-Agent Problem
 How to compensate labor inputs to be sure they are
putting out their best effort.
 Occurs when the principal cannot observe the effort of
the agent.
– Example: Shareholders (principal) cannot observe
the effort of the manager (agent).
– Example: Manager (principal) cannot observe the
effort of workers (agents).
 The Problem: Principal cannot determine whether a
bad outcome was the result of the agent’s low effort or
due to bad luck.
6-25
The Principal-Agent Problem
 Separation of ownership and control
 This creates a fundamental incentive
problem.
 Does a poor year mean low effort or bad
luck or poor demand for the product?
 Manager wants to earn income but is also
enticed by leisure.
 How much leisure (shirking) will the
manager do on the job?
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The Principal-Agent Problem
 Manager 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.
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Solving the Problem Between Owners
and Managers
 Internal incentives
– Incentive contracts – what the manager does under
an incentive scheme depends on relative value of
work versus leisure.
– Stock options, year-end bonuses – if earnings are
largely tied to an incentive bonus then reducing
executive compensation is a mistake.
– Performance-based compensation benefit
stockholders as well as executives.
– Reducing incentives will reduce profits.
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Solving the Problem Between Owners and
Managers
 External incentives outside the firm
– Personal reputation – increased job mobility if
managerial excellence is recognized.
– Threat of takeover – if profits are not being
maximized then another firm could do a buyout and
replace management.
– Even a manager working under a fixed salary would
have the incentive to do a better job.
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Solving the Problem Between Managers
and Workers
 Difficulty in monitoring effort so make income dependent
on performance.
 Profit sharing – tying compensation to the underlying
profitability of the firm.
 Revenue sharing – linking compensation to the
underlying revenues of the firm. (tips, sales
commissions).
 These do not provide an incentive for workers to
minimize costs.
6-30
Solving the Problem Between Managers and Workers
 Piece rates – pay depends on output produced. To earn
more one has to produce more.
 Effort must be expended in quality control
 Time clocks – not very useful in dealing the principalagent problem. Do not monitor effort.
 Spot checks – allows monitoring of presence, effort,
and quality.
 Must be random to be effective and frequent enough so
that workers are concerned about demonstrating
performance.
 Threats work differently psychologically than
performance bonuses.
6-31
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.
6-32