Managerial Economics & Business Strategy

1. Managerial Economics & Business Strategy Chapter 6 The Organization of the Firm

2. Overview I. Methods of Procuring Inputs • Spot Exchange • Contracts • Vertical Integration II. Transaction Costs • Specialized Investments III. Optimal Procurement Input IV. Principal-Agent Problem • Owners-Managers • Managers-Workers

3. Procuring Inputs • What is the optimal way to acquire the efficient mix of inputs? • How does the firm assure it is operating on the cost function? • Least cost must be applied to methods of obtaining inputs as well as their use. • How can the owners of a firm make sure that workers are putting forth maximum effort?

4. Manager’s Role • Procure inputs in the least cost manner, like point B. • Provide incentives for workers to put forth effort. • Failure to accomplish this results in a point like A. • Achieving points like B managers must • Use all inputs efficiently. • Acquire inputs by the least costly method. Costs C(Q) A $100 B 80 Q 10 0

5. Methods of Procuring Inputs • Spot Exchange • When the buyer and seller of an input meet, exchange, and then go their separate ways. • Buyer and sellers are anonymous. • No legal relationship between the buyer and seller. • Advantage – specialization • Used when inputs are standardized and there exist many potential suppliers.

6. Methods of Procuring Inputs • Contracts • A legal document that creates an extended relationship between a buyer and a seller over a specific period of time. • Allows specialization for both sides involved in a contract. • Works well when contract specification is easy. • Disadvantage – costly to write and cover all contingencies. • In complex environments contracts will be incomplete

7. Methods of Procuring Inputs • Vertical Integration • When a firm shuns other suppliers and chooses to produce an input internally. • Loses gains of specialization • Firm has to manage both inputs and output. • Advantage – no longer reliant on others for inputs • Smart plant - JIT • River Rouge - VI

8. Key Features • Spot Exchange • Specialization, avoids contracting costs, avoids costs of vertical integration. • Possible “hold-up problem.” • Contracting • Specialization, reduces opportunism, avoids skimping on specialized investments. • Costly in complex environments. • Vertical Integration • Reduces opportunism, avoids contracting costs. • Lost specialization and may increase organizational costs.

9. Transaction Costs • Costs of acquiring an input over and above the amount paid to the input supplier. • Includes: • Search costs. • Negotiation costs. • Other required investments or expenditures. • Some transactions are general in nature while others are specific to a trading relationship.

10. Transaction Costs • Specialized investment – expenditure that allows exchange but has little or no alternative use. • Generally specialized investments are sunk costs. • Relationship specific exchange – one or both parties have made a specialized investment. • Boeing /Airbus – Rolls Royce – General Electric – Pratt & Whitney

11. Specialized Investments • Types of specialized investments: • Site specificity – locating physical plants in close proximity. • Coal fired electricity generators and mines; • trans-shipment facilities close to ports; • auto parts manufacturers and auto assembly plants. • Physical-asset specificity – capital equipment needed to produce an input needed by a specific buyer cannot be used to produce an input for another buyer. • Automobile headlamps

12. Specialized Investments • Dedicated assets – investments made to enable exchange with a specific buyer. • Occurs many times in government procurement. • Human capital – skills non-transferable to other uses. • Government procurement again is a good example.

13. Specialized Investments • Lead to higher transaction costs • Costly bargaining – implies only a few parties are prepared for a trading relationship. • No market price for the input. • Both sides negotiate a price. • Parties may engage in strategic behavior. • Underinvestment – less interest in quality as the relationship may be short term.

14. Specialized Investments • Opportunism and the hold-up problem – attempting to take advantage of the firm making a specialized investment by taking advantage of the investment’s sunk nature. • Makes firms reluctant to engage in relationship-specific investments unless contracts can be structured to mitigate this problem. • If both parties are required to make specialized investments both may engage in opportunism. • Higher transactions costs to avoid this scenario.

15. Spot Exchange • Many buyers and sellers • Few transactions costs • Opportunism may occur if specialized investments are part of the production process. • May need to bargain each time an input is purchased.

16. Contracts • Requires up-front expenditures • Input prices can be specified before specialized investments are made. • Longer term commitment allows both buyer and seller to invest in quality specialized investments. • Where the gains from opportunism are large, contracts are needed.

17. Contracts • How long should a contract last? • Depends on MC and MB of extending the contract. • MC of extending contract length increase as contracts become longer because of the greater array of possible contingencies. • Economies are dynamic; business conditions change. • MC of contract length is upward sloping.

18. Contracts • MB of extending a contract is the Transactions Costs avoided including opportunism and bargaining. • Optimal contract length increases when level of specialized investment required to facilitate an exchange increases. • As inputs become more standardized and economic environment more certain, MC of writing longer contracts decreases leading to longer contracts and vice versa.

19. MC MB1 MB0 L0 L1 Specialized Investments and Contract Length $ Due to greater need for specialized investments Longer Contract Contract Length 0

20. MC0 MC2 MB0 L0 L2 Specialized Investments and Contract Length $ More complex contracting environment Shorter Contract Contract Length 0

21. MC0 MC1 MB0 L0 L0 Specialized Investments and Contract Length $ Less complex contracting environment Longer Contract Contract Length 0

22. Vertical Integration • Benefits: • Ideal when specialized investments generate transactions costs • Or the product is very complex • Or the economic environment is plagued by uncertainty • Firm moves up the production stream and produces increasingly basic inputs. • Firm avoids the middleman. • Reduces opportunism

23. Vertical Integration • Disadvantages: • Market discipline is replaced by internal regulatory mechanism. • Firm no longer specializes in what it does best. • Vertical integration should be viewed as a last resort only when spot exchange or contracts are not suitable or have failed.

24. Spot Exchange No Substantial specialized investments relative to contracting costs? Yes Complex contracting environment relative to costs of integration? No Yes Vertical Integration Contract Optimal Input Procurement

25. The Principal-Agent Problem • How to compensate labor inputs to be sure they are putting out their best effort. • Occurs when the principal cannot observe the effort of the agent. • 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.

26. The Principal-Agent Problem • Separation of ownership and control • This creates a fundamental incentive problem. • Does a poor year mean low effort or bad luck or poor demand for the product? • Manager wants to earn income but is also enticed by leisure. • How much leisure (shirking) will the manager do on the job?

27. The Principal-Agent Problem • Manager must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm. • Shareholders must create plans to align the interest of the manager with those of the shareholders.

28. Solving the Problem Between Owners and Managers • Internal incentives • Incentive contracts – what the manager does under an incentive scheme depends on relative value of work versus leisure. • Stock options, year-end bonuses – if earnings are largely tied to an incentive bonus then reducing executive compensation is a mistake. • Performance-based compensation benefit stockholders as well as executives. • Reducing incentives will reduce profits.

29. Solving the Problem Between Owners and Managers • External incentives outside the firm • Personal reputation – increased job mobility if managerial excellence is recognized. • Threat of takeover – if profits are not being maximized then another firm could do a buyout and replace management. • Even a manager working under a fixed salary would have the incentive to do a better job.

30. Solving the Problem Between Managers and Workers • Difficulty in monitoring effort so make income dependent on performance. • Profit sharing – tying compensation to the underlying profitability of the firm. • Revenue sharing – linking compensation to the underlying revenues of the firm. (tips, sales commissions). • These do not provide an incentive for workers to minimize costs.

31. Solving the Problem Between Managers and Workers • Piece rates – pay depends on output produced. To earn more one has to produce more. • Effort must be expended in quality control • Time clocks – not very useful in dealing the principal-agent problem. Do not monitor effort. • Spot checks – allows monitoring of presence, effort, and quality. • Must be random to be effective and frequent enough so that workers are concerned about demonstrating performance. • Threats work differently psychologically than performance bonuses.

32. Conclusion • The optimal method for acquiring inputs depends on the nature of the transactions costs and specialized nature of the inputs being procured. • To overcome the principal-agent problem, principals must devise plans to align the agents’ interests with the principals.