ECONOMICS 3200B Lecture 3 Ch. 2 September 23, 2014

1. ECONOMICS 3200BLecture 3Ch. 2September 23, 2014

2. Introduction Markets and players • What is a market? What is capitalism? • Reliance on markets – role of uncertainty, number of competitors • Rules and regulations: role of governments • Ex ante vs. ex post rule making – political risk • Ability to influence rule makers • Market boundaries: Who’s in, who’s out? • Who’s waiting to get in? • Are the boundaries shifting? • Geographic/product?

3. Introduction Teams • Creation of clubs/teams – tribalism • Reinforce early success • Limit competition among members • Economies of scale • Solution to imperfect information, absence of trust • Enhance benefits for all members • Exclusionary • Language, race, religion, culture, nationality, socio-economic

4. Introduction Firms • Organization that transforms inputs into outputs • Collection of people working as team • Existence of firms • Limited liability – raising capital • What does a “firm” maximize? • Who makes the key decisions and why? • Separation of ownership and control • How is accountability managed within the firm? • How are they/how should they be organized?

5. Firms • What is a firm? • Legal structure – corporations, partnerships, sole proprietorships • Ownership of a firm • Private, public, government, not-for-profit • Potash/Air Canada/Petro-Canada/CNR all started as Crown Corporations; privatized • Is government ownership needed? Consider Hydro One, OPG, TTC, LCBO, CMHC, GTAA, AECL, CDIC, Canada Post, EDC, Via Rail • Objectives of a firm • Advantages of a firm • Organization and governance of firms

6. Existence of Firms • Technological • Transactions costs • Contractual

7. Existence of Firms Technological • Team production • Economies of scale – specialization through scale, learning by doing; comparative advantage in use of resources; larger number of production technologies available; indivisibilities • Q(X10) + Q(X20) < Q(X10, X20) • Lower cost to meter/monitor team members internally within firm than externally via the market • Economies of massed reserves through ownership of assets • Insurance against machine breakdowns • Diversification across markets to reduce peak-load capacities • Indivisibilities/synergies in overhead functions: sales, marketing, finance, engineering, legal, research, distribution • Economies of scope

8. Existence of Firms Technological • Need to supervise/monitor/meter • Supervisor measures efforts, determines rewards • Bounded rationality limits scope of control • Rules for compensation – subjectivity, favoritism • Who monitors the monitor? • Compensation to motivate employees • Seniority systems • Vested pensions – less important because of systemic deficits with defined benefit plans • Performance-based bonuses

9. Existence of Firms Technological • Limits because of diseconomies of scale • Shirking – free riding: benefits of leisure accrue to individual, costs of leisure (reduced effort) shared by all members of team • Monitoring and metering costs to minimize shirking • Difficulty in measuring individual effort/contribution • Bounded rationality, noise in transmission of information • Hierarchical organization structure – “guard”/unproductive labor • Boredom and specialization • Motivation – risk aversion

10. Existence of Firms Value Chain and Internalization Primary Activities: • Raw materials  Inbound Logistics  Operations (Manufacturing)  Outbound Logistics  Marketing  After-Sale Service • Operations can be sub-divided into • Fabrication of Materials  Production of Parts  Sub-assembly  Final Assembly • For service activities, the value chain would look different

11. Existence of Firms Value Chain and Internalization Support Services, which overlay the Primary Activities: • Firm Infrastructure – finance, planning, legal • Human Resource Management • Technology Development • Procurement

12. Existence of Firms Options • Markets and firms alternative means for completing related sets of transactions • Short-term contracts – costs, uncertainty re. supply • Long-term contracts – opportunistic behavior • Ownership/control – internalization

13. Existence of Firms Transactions costs: • Costs in using markets • Search costs – suppliers, prices • Negotiating, writing, monitoring and enforcing contracts • Classical firm as nexus of contracts – hub/spoke • Duration of contracts and increasing complexity • Uncertainty re. future states • Increasing number of contingencies – increasing complexity • Incomplete contracts – trade-offs between more complex contracts/higher costs and simpler, incomplete contracts • Opportunistic behavior – incentives to breach contracts • Proprietary rights to information – investment ideas, market demands, product design, service innovations, etc. • Value depends on package of rights and other factors – cannot contract for all factors

14. Existence of Firms • Internalization (insourcing)– avoid using marketplace by ownership of inputs, expansion of value-added activities conducted within firm • Vertical integration – back to value chain and support activities • Bargaining power vis a vis market – credible threat to shift production • Inefficiencies as firm becomes larger • Control problems associated with bounded rationality (limits to information any person can absorb and massage); weak incentives (difficulty in measuring direct contributions of individuals or divisions to overall financial performance of company); distortion as information (decisions) pass through more levels within organization

15. Existence of Firms Internalization • Vertical integration, horizontal diversification • Reduce transactions costs • Economies of scale, scope • Transferability of source of competitive advantage (design, marketing, costs, superior management, reputation) • Proprietary information • Tax advantages – transfer pricing • Quality control – minimize liability risks; Boeing and 787 • Entry deterrence – BCE, Rogers and MLSE; BCE and Astral; Airlines and slots; Apple and Apple stores; banks and branches • Circumvent rate of return regulations

16. Existence of Firms Disadvantages of Internalization • Diseconomies of scale – outsourcing • Internal transfer prices and corporate politics • 3rd party opportunities for internal divisions – economies of scale, creating opportunity for competition

17. Existence of Firms • Advantages of engaging in market transactions – outsourcing (near-sourcing) a new term for an old idea, namely, using the market to acquire inputs or sell outputs • Specialization/focus for firm • Market prices serve as reference points for internal transfer pricing • Economies of scale – ability to serve 3rd party customers • Link between performance/rewards

18. Existence of Firms Optimal size of firm • MC of internalizing vs. MC of external transactions • Diseconomies of scale vs. economies of scale/scope • Technological change (communications, transportation, organization) • Optimal size differs across industries, time, location (country-specific characteristics) • Costs – e.g. transportation costs; reputation • Optimal size different question than why do firms grow

19. Typology of Costs Variable costs, fixed costs • Time dimension • Fixed costs • Independent of output • May be fully or partially recoverable if firm exits • Variable costs • Vary with rate of production • Demand variability and ratio of fixed to variable costs • Cyclical industries

20. Typology of Costs Fixed costs, sunk costs • Distinction between sunk and fixed costs: no market value; no retrieval/scrap value • Sunk costs • Not recoverable if firm exits or fails • Specialized equipment with zero scrap value – no alternative uses • Specialized investment: wastewater treatment plant; specialized dies/molds; advertising campaign; advisory fees (investment banking services for raising capital or acquisition/divestiture) • Ex post, sunk costs do not impact pricing or other strategic decisions • By-gones are by-gones – historical costs not important for decision-making; what matters are actual current market values

21. Typology of Costs • Ex ante vs. ex post costs of investment – prior to making an investment, must consider the size of the investment (the actual current cost of physical capital to be acquired or the R&D or marketing budget); following approval of the investment, only the opportunity cost of the actual current market value of the investment matters in the decision-making process • Pricing of hotel rooms, seats on planes, rental cars, cloud computing – inventory committed so fixed costs become sunk costs if inventory not used/sold (investment in an empty hotel room or an empty seat on a flight or server capacity is not recoverable)

22. Typology of Costs Opportunity costs • Consider in decision-making re. investment strategies • Investing in new equipment: cost of capital – opportunity cost of capital, e.g. equity • Cost of equity: expected return on next best investment opportunity with comparable risk profile, i.e. bankruptcy risk • Equity a higher cost source of capital than debt even though there are no fixed interest payments

23. Typology of Costs Opportunity costs • Fully depreciated real estate, capital equipment: opportunity cost is return on selling these assets and investing the market price proceeds; even if fully depreciated, market value of assets should be factored into investment/strategic decisions of company • Non-performing loans – market for non-performing loans priced at discount to face value • Non-performing loans should be written down to prevailing market price – loans generally marked to market

24. Typology of Costs Marginal, average variable, average fixed and average total costs • Marginal costs: change in total costs (variable costs) resulting from increased production/distribution of one unit • Average variable costs: total variable costs divided by total number of units produced • Average fixed costs: total fixed costs divided by total number of units produced • Average total costs: sum of average variable costs and average fixed costs • Shut-down point – if negative cash flows with AVC < P < ATC, will creditors provide additional financing?

25. Costs • Determinants of total costs • Input prices; quantities of each input; value chain activities; transportation costs; distribution costs • Trade-offs between economies of scale and transportation costs

26. Costs • Input prices • Location of the company • Location of the sources of inputs • Exchange rates • Hedging • Transportation costs • Tax and tariff rates • Bargaining power • Quality of the inputs • External (outsourcing) vs. internal (insourcing) transactions

27. Costs • Quantities of each input • Technology • Organization structure – X inefficiency • Economies of scale – external, internal • Learning curves • Quality of inputs • Relative prices • Production rates – peak load, smoothing and inventories, overtime

28. Cost Minimization • Minimize costs – unit costs (average total costs), marginal costs, fixed costs, total costs • Minimizing unit costs may require operating at or near capacity – optimal capacity level • Different technologies for different levels of capacity – flexibility, different cost structures • Economies/diseconomies of scale – level of demand • Economies of scope • Rate of production • Time frame for minimizing costs – adjustment opportunities, competitive disadvantages for slow adjustment, behavior of competitors, adjustment costs • Can any company afford not to focus on minimizing costs?

29. Cost Minimization • Decisions facing companies: • Production technologies: flexibility for production, substitutability among inputs, knowledge about alternative technologies, vintage of technologies, optimal level of capacity, skills to accommodate different technologies (training) • Does company use different production technologies in different countries? • Location: exchange rates and costs, tax rates, subsidies, input prices, transportation costs • Organization structure – HR policies • Rate of expansion, pricing: first mover advantages (economies of scale, learning curves); first mover disadvantages (selecting inferior technologies, wrong set of value chain activities) • Investment in capacity in anticipation of increased sales volume, e.g. new production equipment imbedding latest technologies

30. Cost Minimization • Value-added chain scope for company • What should a company do? • Core competencies, basis for competitive advantage critical as is organization structure, diseconomies of scale and importance of control over proprietary information or distribution • Boundaries for a firm: what should it buy in marketplace, where should it come in contact with marketplace, internalizing vs. outsourcing?