Overview
Economics 3030
I. Methods of Procuring Inputs
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Chapter 6
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The Organization of the Firm
Spot Exchange
Contracts
Vertical Integration
II. Transaction Costs
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Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
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Owners-Managers
Managers-Workers
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Methods of Procuring Inputs
Manager’s Role
• Procure inputs in the
least cost manner
• Provide incentives for
workers to put forth
effort
• Failure to accomplish
this results in a point
like A
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• Spot Exchange
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Costs
C(Q)
A
$100
80
When the buyer and seller of an input meet, exchange,
and then go their separate ways.
• Contracts
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A legal document that creates an extended relationship
between a buyer and a seller.
• Vertical Integration
Output
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$10
When a firm shuns other suppliers and chooses to
produce an input internally.
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Pros and Cons of Each Method
Transaction Costs
• Spot Exchange
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Specialization, avoids contracting costs, avoids costs of
vertical integration.
Possible supply problems (i.e.,“hold-up problem”)
• Contracting
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Specialization, reduces opportunism, avoids skimping
on specialized investments
Costly in complex environments, incomplete contracts
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• Vertical Integration
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• Costs of acquiring an input over and above
the amount paid to the input supplier.
• These must also be included in a cost
calculation:
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Reduces opportunism, avoids contracting costs
Lost specialization, organizational costs
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Search costs
Negotiation costs
Other required investments or expenditures to facilitate
exchange (e.g., transportation costs)
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1
Specialized Investments
Optimal Input Procurement
• Investments made to allow two parties to
exchange but has little or no value outside of the
exchange relationship
Site specificity
Physical-asset specificity
Dedicated assets
Human capital
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• Cost minimization depends on the extent of
relationship-specific exchange
• Spot Exchange
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• Contracts
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• Implications of specialized investments
Higher transactions costs because of bargaining
Underinvestment
Opportunism and the problem of “hold-up”
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Higher transactions costs (due to underinvestment,
opportunism and bargaining) if specialized investment.
Costly but reduces the above problems of
underinvestment and opportunism.
• Vertical Integration
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When contracts are just too costly, but reduces
specialization of the firm. Method of last choice.
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Specialized Investments, Contract
Complexity, and Contract Length
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Optimal Input Procurement
MC1
$
Substantial
specialized
investments
relative to
contracting costs?
MC0
MB1
No
Yes
Due to greater need for
specialized investments
Spot Exchange
Complex contracting
environment relative to
costs of integration?
MB0
No
Due to increased
complexity of contract
Shorter
Contract
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L2
Longer
Contract
L0
L1
Contract
Length
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The Principal-Agent Problem
• Occurs when the principal cannot observe the
effort of the agent
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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
Contract
Vertical
Integration
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Solving the Problem Between
Owners and Managers
• Internal incentives
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Incentive (or performance-based) contracts
Stock options, year-end bonuses
• External incentives
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n
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Yes
Personal reputation
Potential for takeover
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Solving the Problem Between
Managers and Workers
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Summary
• A manager must decide which inputs to
procure and how to get the most from these
inputs.
• Spot markets, contracts, and vertical
integration are all ways to obtain inputs
depending on the nature of the input.
• Solving the principle-agent problem is
essential to getting the most from managers
and employees.
Profit sharing
Revenue sharing
Piece rates
Time clocks and spot checks
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