Notes for Chapter 6

1. Notes for Chapter 6 (Supplemental to the written notes provided in class) (Do not distribute)

2. Organizational Design What economic factors determine the size and breadth of firms? Why do some economic transactions take place within firms, whereas others are transacted via markets? What can economic analysis say about the likely ways in which firms are organized?

3. Background - The Nature of the Firm About a century ago, the typical firm in the industrial world was a very small concern, managed by its owners and employing a small number of workers. Only the railroads, steel producers and some other manufacturers were the large firms. Today, the firms are bigger – for example, the firm size can be (amongst others) 50 employees, 250,000 employees or even more than 2 million. Although firms range in size from the single proprietor to the largest Fortune500 companies, the vast majority of managers work for firms with 50 or more employees. According to Coase, “ Firms will be organized to minimize the total cost of production including transaction costs.” (R. Coase, “ The Nature of the Firm,” Econometrica (1939): 386-405

4. The owner-managed firm.. This firm was the norm in the nineteenth century and still represented today. Consider a small clothing producer, run by a sole proprietor who was both owner and manager. The proprietor got the necessary equipment, hired workers, and made all important decisions. As sole owner, the proprietor claimed all profits (and paid all losses) from the business. He/she had a strong incentive to take optimal actions because ultimate profit depended on it.

5. The large-scale firm Contrast this with the large-scale firm today. Due to the economies of scale, average costs decline at higher levels of output. This explains (partially) the large firm size. But the big scale makes the business of transforming inputs into outputs much more complicated. It is not possible for a single owner-manager to take on all management responsibilities. “The modern firm distributes information and management responsibilities among a wide group of inside managers. Today’s firm is an organization based on a set of agreements and contracts..”

6. Organization Structure On the one hand, a large scale firm has the advantage of declining average costs, on the other hand, the division of management responsibilities raises many problems. The design of the organization structure involves many aspects such as determining the vertical boundaries of the firm, having mechanisms for monitoring and rewarding managers and other firm employees etc.

7. Vertical Boundaries of the Firm Vertical boundaries of a firm define the activities that the firm itself performs as opposed to purchases from independent firms in the market. The production of any good or service, from music recordings to medical treatments, usually require many activities. The process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and services is known as the vertical chain.

8. Vertical Chain A central issue in business is how to organize the vertical chain. Is it better to organize all of the activities in a single firm, or is it better to rely on independent firms in the market? This takes us to the make-or-buy decision of a firm.

9. Make Vs. Buy • A firm’s decision to perform an activity itself or purchase it from an independent firm is called a make-or-buy decision. • Make means the firm performs the activity itself. • Examples: Italian fashion icon Benetton dyes fabrics, designs and assembles clothing, and operates retail stores. • Kimberly Clark’s Scott Paper division owns forest land, mills timber, and produces consumer paper products. • Buy means it relies on an independent firm to perform the activity. • Two types of ‘Buy’ considered in the text : Spot Exchange and Contracts.

10. Question: Spot Exchange (Buy), Contracts (Buy) or Vertical Integration (Make)? • A major oil company refines gasoline from crude oil produced by oil wells that it owns. • Transcontinental, an interstate natural-gas pipeline, has a legal obligation to purchase a specific amount of gas per week from a well owned by Fred Smith in Enid, Oklahoma • A cabinetmaker purchases a dozen wood screws from the local hardware store.

11. Textbook Question: Spot Exchange (Buy), Contracts (Buy) or Vertical Integration (Make)? Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next three years from AMI. The price paid in the first year is $200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years. Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine. Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.

12. Spot Exchange (Buy) • We just saw in the previous slides the two ways by which a firm can ‘Buy’. • One of the methods of buying inputs from outside suppliers is through Spot Exchange. • Spot Exchange (Text): • Occurs when the buyer and seller meet, exchange, and then go their separate ways. • Buyers and sellers are anonymous; the parties may make an exchange without even knowing each other’s names. • There’s no legal/formal relationship between buyer and seller. • It is useful when the input is ‘standardized’, there are negligible/low transaction costs, market firms are subject to the discipline of the market, the market price is determined by the intersection of demand and supply etc.

13. Contracts (Buy) • Another method of buying inputs is through Contracts. • Where have you seen a contract? • ‘Conditions of contract’ on the back of an airline ticket! Think of more examples.. • Contract: A legal document that creates an extended relationship between a buyer and seller of an input. • It defines the conditions of exchange. • It may be short, or lengthy and complicated. • It specifies the set of tasks that each contracting party expects the other to perform. • It also specifies remedies in the event that one party doesn’t fulfill its obligations. • An injured party may go to court to enforce the contract. • Example: Here’s a website having general examples of contracts. (Use this website for general learning about contracts only ). Check out the example on delivery contract.

14. Contracts A contract allows a firm to buy ‘nonstandard’ inputs for which there may not be many suppliers. However, a contract that satisfies both the parties may be time-consuming and costly to write. Additionally, having the parties cover all the contingencies that could occur in the future would be tough – that would make the difference between complete and incomplete contracting.

15. Extra Information: Complete and Incomplete Contracting A complete contract has each party’s responsibilities and rights for each and every contingency that could possible arise during the transaction. A very difficult/ impossible proposition! The parties must be able to think of all the contingencies, and agree on actions for every contingency. The parties should be able to stipulate what constitutes satisfactory performance. The parties should be able to measure performance. Etc. We can say that virtually, all actual contracts are incomplete – they don’t fully specify every possible contingency that can be mapped to rights, responsibilities, and actions. There are circumstances under which neither party’s rights and responsibilities are clearly spelled out – Incomplete contracting!

16. Vertical Integration (Make) As we saw earlier, if a firm makes an input internally, then it is said to have Vertical Integration. Now the firm is a bigger organization! It has to produce its output and also the inputs to produce the output There are more departments to be managed, and this will increase the bureaucratic costs. Example: Microsoft buys Nokia’s phone business(later sold off)

17. Optimal Decision? For understanding which decision is optimal for the firm, we need to be clear about the meaning of Specialized investments and the effect of specialized investments on transaction costs.

18. Relationship-Specific Exchange • Class Notes • Example: • A car manufacturer has developed a new high-performance and uniquely designed fuel injection system. This will increase fuel efficiency and help sell more cars. • Manufacturing this uniquely designed system requires investments in a machine that can be used only for this purpose. • The machine cannot be used to make fuel injection systems for any other automaker. • Thus, investment in this machine constitutes a specialized investment. • If the car manufacturer asks an independent supplier to provide this specialized asset, then mutual dependency is created. They are in a relationship-specific exchange, and are ‘tied together’. • We’ll see more on this later.

19. Types of Specialized Investments Class Notes

20. Transaction Costs Class Notes Example: If a carpenter wants to buy wood for making a table, his cost will be not only the price of wood, but will also include the extra effort he spends in searching the right kind of wood, where to get it and at what price, his cost of traveling to the store and back and the time waiting in line etc. – these costs above the cost of wood are the transaction costs.

21. Specialized Investments and Transaction Costs (Text) • Specialized Investments involve higher transaction costs because of the following reasons: • Costly Bargaining: The two parties in the relationship-specific exchange bargain with each other over the price of the input. The bargaining process is generally costly, as each party tries to get a more favorable price. • Underinvestment: The specialized investment may be lower than optimal. For example, if a seller of a specialized machine is not able to sell to the buyer it was made for, then the seller cannot use it anywhere else. The seller has the incentive to produce a cheaper machine. • Opportunism and Hold Up Problem: When a specialized investment must be made to acquire an input, the buyer or seller may attempt to capitalize on the “sunk” nature of the investment by engaging in opportunism, and cause the hold-up problem.

22. Example Let’s go back to the example of a car manufacturer who needs a uniquely designed fuel-injection system for his car. Remember that the machine for producing the uniquely designed fuel-injection system can be used only for this purpose; it cannot be used to make fuel injection systems for any other automaker.

23. Example Suppose an independent supplier has been asked by the car manufacturer to make this investment. The supplier might reason that once it has made the investment, it’ll become dependent on the car manufacturer for business. Why? Because this car manufacturer is the only possible customer for the output of this equipment. The supplier perceives this as putting the car firm in a strong bargaining position, and worries that once the specialized investment has been made, the car firm can use this position to squeeze down prices for the system.

24. Example The car firm might think that it might become too dependent on that supplier for a vital input. Because specialized equipment is required to produce the fuel injection systems, the car firm cannot easily switch its orders to other suppliers who lack that equipment. Thus, the dependency may create opportunism problems (and hence high transaction costs) for the car firm.

25. Analysis - Optimal Input Procurement Class Notes Example (Text): Jiffyburger, a fast-food outlet, sells approximately 8000 quarter-pound hamburgers in a given week. To meet that demand, Jiffyburger needs 2000 pounds of ground beef delivered to its premises every Monday morning by 8 am sharp. As the manager of Jiffyburger, what problems would you anticipate if you acquired ground beef using spot exchange? This is a dedicated asset (specialized investment) – delivering one ton of meat to a particular store. Jiffyburger can face ‘hold-up’ problem, as the meat supplier may try to ask for a higher price at 8 am. Jiffyburger will be stuck and will find it hard to find another meat supplier on such short notice. Or the meat supplier may supply low quality meat. Thus spot exchange can involve problems like opportunism, bargaining and underinvestment. Managers then must consider alternatives to spot exchange.

26. Contracts – Alternative Class Notes

27. Vertical Integration - Alternative Class Notes

28. Vertical Integration (Text) • Use when inputs require • a substantial specialized investment. • generate significant transaction cost. • complex contracting or uncertain economic environments. • Advantages: • “Skips the middleman.” • Reduces opportunism. • Mitigates transaction costs. • Disadvantages: • Managers must create an internal regulatory mechanism. • Bear the cost of setting up production facilities. • No longer specialized in producing its output.

29. The Economic Trade-Off No Yes No Yes

30. Practice Question In general, automobile manufacturers produce their own engines but purchase tires from independent suppliers. Why? Engine manufacturing involves specific investments; by vertically integrating, the potential for opportunism is reduced. Tires are more uniform and can usually be purchased by spot exchange.

31. Practice Question As a manager of the ABC corporation, you have negotiated with several vendors and are on the verge of signing an 8-year contract with Bolts enterprises. Under the contract, they would ship to you 2,000 titanium bolts per month at a price of $1,000 per bolt. Your assistant has just brought you an article from a trade publication that indicates that another company has developed a new technology that reduces the cost of producing the titanium bolts. How would this information affect the optimal length of your contract with Bolts Enterprises? Explain. The reduction in another supplier’s cost of producing titanium bolts reduces ABC’s marginal benefit of contracting. Therefore, the eight-year contract it has been negotiating is too long; the optimal contract length is now less than eight years.

32. Principal-Agent Problem Class Notes

33. Separation of ownership and control (P-A problem) • Owners have to incentivize managers since they are not present to monitor. • Manager’s economic trade-off • Leisure. • Labor. • Fixed salary • Receives wage independent of labor hours and effort. • No strong incentive to monitor other employees labor hours and effort. • Adversely impacts firm performance. • Incentive contract • Tie manager wage to firm performance (like profits). • Manager makes labor-leisure choice and is compensated accordingly.

34. Incentive Contracts • A way to align owners’ interests with that of the actions of its manager. • Examples include: • Stock option • Other bonuses directly related to profits. • 2013 CEO compensation

35. External Incentives • Outside forces can provide manages with the incentive to maximize profits, and include: • Reputation. • Takeover threat.

36. The Manager-Worker Principal-Agent Problem • The owner-manager, principal-agent problem is not unique. • A similar problem exists between the firm’s managers and the employees he or she supervises.

37. Solutions to the Manager-Worker Problem • Class Notes • Why do secretaries get paid hourly wage instead of piece rates?

38. Practice Question Explain why people in the following occupations are compensated as they are. 1. Insurance agents Insurance agents are usually compensated by a fixed base payment and a commission, which is positively related to the amount of business brought to the company. Without the variable part of salary, insurance agents have little incentive to find clients. 2. Authors Authors typically receive royalties, which are revenue-sharing plans whereby the author receives a fraction of the revenues generated by the book. This compensation scheme provides the author an incentive to write a high-quality book in order to generate lots of sales for the firm, and thus lots of royalty income for the author.

39. 3. CEOs of major corporations A CEO of a major corporation is usually compensated by a fixed payment plus a variable bonus positively related to the amount of profits the corporation made. Without the variable part of the payment, the CEO will not put forth as much effort as desired by the principal. 4. Food servers Waiters and waitresses are usually paid a small fixed payment by restaurants. The majority of their pay is derived from tips, since customers can monitor their servers while the restaurant manager cannot.