Chapter 8 The Organization of the Firm
Methods of Procuring Inputs
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Spot market
An informal relationship between a buyer and seller in which neither party is obligated
to adhere to specific exchange.
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Contract
A formal relationship between a buyer and seller that obligates the buyer and seller to
exchange at terms specified in a legal document.
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Produce inputs internally (vertical integration)
A situation where a firm produces the inputs required to make its final product
Transaction Costs
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Cost associated with acquiring an input that is in excess of the amount paid to the input
supplier.
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Types of “obvious” transaction costs
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Cost of searching for a supplier.
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Cost of negotiating a price.
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Investments and expenditures required to facilitate exchange.
Vertical Integration
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Produce inputs internally.
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Use when inputs require
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a substantial specialized investment.
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generate significant transaction cost.
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complex contracting or uncertain economic environments.
Advantages:
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“Skips the middleman.”
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Reduces opportunism.
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Mitigates transaction costs.
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Disadvantages:
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Managers must create an internal regulatory mechanism.
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Bear the cost of setting up production facilities.
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No longer specialized in producing its output.
Compensation and the Principal-Agent Problem
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Having learned about the principal factors in selecting the best methods of acquiring inputs, we
now explain how to compensate labor inputs to put forth maximal effort.
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The primary obstacle is the separation of ownership and control.
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Principal-agent (P-A) problem leads to the following question: Is poor performance due
to
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back luck?
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low manager effort?
Owners have to incent managers since they are not present to monitor.
Incentive Contracts
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A way to align owners’ interests with that of the actions of its manager.
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Examples include:
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Stock option
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Other bonuses directly related to profits.
Outside forces can provide manages with the incentive to maximize profits, and include:
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Reputation.
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Takeover threat.
Solutions to the Manager-Worker Problem
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Manager-worker principal-agent problem solutions:
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Profit sharing.
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Revenue sharing.
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Piece rates.
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Time clocks and spot checks.