Managerial economics Business strategy Chapter 6 The Organization of the Firm Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Managerial Economics & Business Strategy Chapter 6 The Organization of the Firm
Overview I Methods of Procuring Inputs Spot exchange Contracts Vertical Integration I. Transaction Costs a Specialized Investments III Optimal Procurement Input IV Principal-Agent Problem Owners-Managers Managers-Workers Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 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
Managers role Procure inputs in the least cost manner Costs C(Q) Provide incentives for A workers to put forth $100 B effort Failure to accomplish this results in a point like a Dutput $10 Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Manager’s Role • Procure inputs in the least cost manner • Provide incentives for workers to put forth effort • Failure to accomplish this results in a point like A $100 80 0 $10 Output Costs A B C(Q)
Methods of Procuring Inputs Spot exchange When the buyer and seller of an input meet, exchange and then go their separate ways Contracts A legal document that creates an extended relationship between a buyer and a seller Vertical Integration a When a firm shuns other suppliers and chooses to produce an input internally Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Methods of Procuring Inputs • Spot Exchange When the buyer and seller of an input meet, exchange, and then go their separate ways. • Contracts A legal document that creates an extended relationship between a buyer and a seller. • Vertical Integration When a firm shuns other suppliers and chooses to produce an input internally
Key features Spot exchange a Specialization, avoids contracting costs, avoids costs of vertical integration Possible hold-up problem Contracting Specialization, reduces opportunism, avoids skimping on specialized investments a Costly in complex environments Vertical Integration Reduces opportunism, avoids contracting costs ost specialization, organizational costs Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 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, organizational costs
Transaction Costs Costs of acquiring an input over and above the amount paid to the input supplier Includes Search costs Negotiation costs a Other required investments or expenditures Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 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
Specialized Investments Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship ■ Site specificity Physical-asset specificity Dedicated assets Hu uman capita Lead to higher transaction costs and the problem of hold-up Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Specialized Investments • Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship Site specificity Physical-asset specificity Dedicated assets Human capital • Lead to higher transaction costs and the problem of “hold-up
Specialized Investments and Contract Length MC MB Due to greater need for specialIzed investments MB Longer Contract Contract 0 Length Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Specialized Investments and Contract Length MB0 MC L0 $ Contract Length 0 L1 MB1 Longer Contract Due to greater need for specialized investments
Optimal Input Procurement S pot EXchange Substantial specialized Investments relative to Yes Complex contracting contracting costs? environment relative to costs of integration? No Ye Vertical Contract Integration Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Optimal Input Procurement Substantial specialized investments relative to contracting costs? Spot Exchange No Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes Contract No
The Principal-Agent Problem 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 agents low effort or due to bad luck Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 The Principal-Agent Problem • 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
