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ECO 610-401

ECO 610-401. Monday, December 1 st Organizational Design: Centralized vs. Decentralized Readings, Brickley et al., 11-13 Monday, December 8 th Performance Measures Readings, Brickley et al., 16 Extended Assignment 3 due. Exam Distribution. Organizational Architecture.

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ECO 610-401

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  1. ECO 610-401 • Monday, December 1st • Organizational Design: Centralized vs. Decentralized • Readings, Brickley et al., 11-13 • Monday, December 8th • Performance Measures • Readings, Brickley et al., 16 • Extended Assignment 3 due

  2. Exam Distribution

  3. Organizational Architecture • Any complex firm or organization must address: • The assignment of decision rights within the firm • The method of rewarding individuals • The structure of systems to evaluate the performance of both individuals and business units.

  4. The Fundamental Problem • Produce output customers want at the lowest cost • The answer to this challenge is complicated by: • Information held by different parties • Information is expensive to transfer (specific rather than general) • Asymmetric information (workers and supervisors don’t have the same information – principal agent problem) • Incentive Problems

  5. The Market Solution • With Markets individuals have property rights • Prices: • Are a signal • Give incentives • Promote economic efficiency • Decisions tend to be made by individuals with specific knowledge

  6. Architecture within the Firm • No Automatic Systems for: • Assigning decision rights to individuals with information • Motivating individuals with information to use them to promote a firm’s objectives • Decision Rights: • Most firms by Administrative Decision rather than Prices • Grant authority to have control of firm resources by employees not owners • Since employees are not owners, have fewer incentives to use resources efficiently.

  7. Architecture within the Firm (2) • Controls • Necessary to control incentive problems • Consist of: • Reward and performance evaluation • Tradeoffs • In larger firms, CEO can’t know and do all • IF CEO makes decisions will lack information • If CEO tries to get information, will be costly • If CEO delegates decisions to those with information, incentive problems arise

  8. The Determinants of Architecture

  9. Vertical Integration and the Make or Buy Decision • What determines when a firm should make (vertically integrate) or buy (outsource)? • Examined in the simple transfer pricing framework, now add some other considerations

  10. Make or Buy Continuum

  11. Make or Buy Fallacies • Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for the firm • Firms should buy, rather than make, to avoid the costs of making the product. • Firms should make, rather than buy, to avoid paying a profit margin to independent firms. • Firms should make, rather buy, because a vertically integrated producer will be able to avoid paying higher market prices for the input during periods of peak demand or scarce supply. • Firms should make to tie up a distribution channel. They will gain at the expense of rivals.

  12. Benefits and Costs of Using the Market • Benefits • Market firms can achieve economies of scale that in-house departments cannot. • Market firms are subject to the discipline of the market and must be efficient and innovate to survive. Overall corporate success may hide the inefficiencies and lack o innovation of in-house markets. • Costs • Coordination of production flows through the vertical chain may be compromised when activity is purchased from outside vendor. • Private information may be leaked. • There may be costs of transacting with independent market firms that can be avoided by performing the activity in-house.

  13. An Example: Rustic Homes

  14. Rustic Log Cabin (2) • Cabin cost $10,000 each • Costs include • Labor ($4,000) • Lumber • $7,000 • $5,000 • $3,000 • 100 confirmed orders

  15. Rustic Log Cabin (3) • Rustic Cabin is considering 2 options: • Buy lumber from mill • Purchase forest land and mill for annual bank payment of $350,000 ($3,500 per cabin) • Cost of milling is $1,500 • Effective cost of lumber is $5,000 per cabin • Other Options?

  16. Rustic Log Cabin (4)

  17. Reasons to “Buy” • Exploiting Scale and Learning Economies • Agency Costs • “Cost” Centers • do not face market pressures • difficult to measure performance • Influence Costs • Scarce capital and resources in a firm are bid by competing divisions • Lobbying is a waste of resources • Inappropriate allocations as a result

  18. Reasons to Make • Reasons to make are associated with the costs associated with writing and enforcing contracts • Complete versus Incomplete Contracts • Complete contract eliminates opportunistic behavior • Requires knowledge and agreement on all contingencies • Requires enforcement by outside party • The problems arise with contracts because of • Bounded rationality • Difficulties specifying or measuring performance • Asymmetric Information

  19. Reasons to Make (2) • Leakage of Private Information • Transaction Costs • Relation-Specific Assets • Value of assets depends on the relationship – value of assets diminishes if relationship is severed. • Types of Asset Specificity: • Size Specificity • Physical Asset • Dedicated Assets • Human Asset Specificity

  20. The Fundamental Transformation • Need to create relation-specific assets transforms relationships as the transaction unfolds. • Before the transactions, firms can choose the most profitable partnership • After the transaction they will have few alternatives.

  21. Rents and Quasi-Rents • Example: Cup Holders for Ford Taurus • 1,000,000 holders with average variable cost of C per unit • Factory is constructed with loan with interest of I per year. • TC = I + 1,000,000C • Expect Ford to buy. If not sell to “jobbers” to resell at price of Pm giving revenue of 1,000,000Pm

  22. Rents and Quasi-Rents (2) • Suppose Pm > C then ignoring I, profit is 1,000,000(Pm-C) but • I > 1,000,000(Pm-C) then • I - 1,000,000(Pm-C) represents relation-specific investment (RSI) • Amount of investment firm cannot recover if it doesn’t do business with Ford • If I = $8,500,00, C = 3, and Pm = 4 then RSI = 8,500,000 – 1,000,000(4-3) = 7,500,000 • Suppose Ford will pay P* > Pm • Rent is 1,000,000(P*-C) – I, profit you expect

  23. Rents and Quasi-Rents (3) • Quasi-Rent • Suppose the deal with Ford falls through • I is a sunk cost and sell to Jobbers if PM > C • Quasi-Rent = [1,000,000(P*-C)-I] - [1,000,000(PM-C)-I] = 1,000,000(P*-PM) • Extra profit if deal goes through

  24. The Hold-Up Problem • If Quasi-Rent is large, firm has a lot to lose in second-best alternative. • This gives the possibility of hold-up through renegotiation when contractions are incomplete • Example: P* = 12, PM = 4, C = 3, I = 8,500,000 • At P*=12, Rent is 500,000 per year • Quasi-Rent is (12-4)1,000,000 = 8,000,000 • If Ford renegotiates down to $8, it increases its profits by $4,000,000 • You lose (8-3)1,000,000-8,500,000=-3,500,000

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