Lecture 10 Economic Theory of the Firm There are two views of the firm: 1. Neoclassical (traditional) theory: Firm is a calculating entity, that makes decisions, buys inputs, making output, and selling for profit for loss Firm is a calculating entity, that makes decisions, buys inputs, making output, and selling for profit for loss 2. Property rights theory: Firm is a collection of contracts between owners of resources, who wish to combine portions of their resources, for some period, for some purpose Firm is a collection of contracts between owners of resources, who wish to combine portions of their resources, for some period, for some purpose

Traditional Theory of the Firm Traditionally, the firm — headed by the entrepreneur or manager — makes decisions: Traditionally, the firm — headed by the entrepreneur or manager — makes decisions: –What to produce? –When and how to produce it? –How much to produce? –What is its price? The firm is seen as having a production function: The firm is seen as having a production function: –Relates inputs and outputs — like a recipe q = q (x,y,z) q = q (x,y,z) q is output q is output x, y, z are inputs x, y, z are inputs –The exact form depends on technology, etc.

A production function A production function is often a mechanical view of production: A production function is often a mechanical view of production: –1 shovel of cement –3 shovels of sand –5 shovels of stone –4 liters of water –Use labor to mix cement, sand, and stone for 1 minute –Add more water to get right texture –Use labor to mix ingredients for 2 minutes –Output: 12 liters of wet concrete Most of this is engineering. The role of economics is limited to the importance of price, substitutes, etc. Important concepts, but not difficult to grasp.

Property Rights Theory: Firms and Markets The tradeoff: –Market is informationally efficient –The firm is contractually efficient The balance between these two determines the methods of production chosen by an entrepreneur or manager The balance between these two determines the methods of production chosen by an entrepreneur or manager

What Kind of Organizational Form to Choose? A key role of managers is to procure inputs in the least cost manner. If not accomplished, costs will be higher than needed and the firm will lose profits and perhaps go bankrupt. Basic Question: To achieve greater efficiency, does a manager procure inputs from the market or procure inputs within the firm?

How to obtain needed inputs? Consider possible stages of production: Obtaining raw materials Obtaining finished parts Assembly Transportation services StorageWholesalingRetailing

How to obtain needed inputs? General services needed by a firm: Accounting Finance (including credit service) Human Resources Legal Services Marketing (advertising, etc.) Janitorial Service Who is to provide such services?

Who provides needed services and materials? Should the firm produce within the organization or buy from the outside? Should the firm produce within the organization or buy from the outside? There is no one answer—many conditions will determine outcome. There is no one answer—many conditions will determine outcome. Think of the great range of options: Think of the great range of options: Spot markets → Long Term Contracts → Vertical Integration (produce in house)

Inputs Can Be More Costly than Necessary Study of a ship building firm showed transaction costs were 14% of the total cost of construction. Study of a ship building firm showed transaction costs were 14% of the total cost of construction. Wrong decisions about how to obtain inputs are costly. Wrong decisions about how to obtain inputs are costly. Some internal inputs that could have been bought for less from outside increased cost as much as 70%. Some internal inputs that could have been bought for less from outside increased cost as much as 70%. External purchases that could have been done in- house for less increased cost as much as 300%. External purchases that could have been done in- house for less increased cost as much as 300%.

Methods of Obtaining Inputs 1.Spot market or spot exchange— Buyers and sellers exchange, but might not deal again. Benefits: deal with specialized sellers, who often have economies of scale not possible within the firm, and usually low transaction costs. The provider is not integrated into the firm. Possible problems: Exploitation by seller who knows we are ignorant; inconsistent quality; lack of internal coordination. Information leaks to competitors. Products involved are usually generic.

Methods of Obtaining Inputs 2. Contracts— Legally based extended relationship between buyer and seller. Benefits: Specialization; ability to terminate sellers who do not perform; reduction in exploitation compared to spot markets. Problems: Costly in complex environments; difficult to specify quality exactly and to measure quality; unforeseen problems including liability issues.

Contracting Complexity: Ford Ford used annual bidding competition to achieve low cost suppliers for auto parts ($7 billion a year). Ford used annual bidding competition to achieve low cost suppliers for auto parts ($7 billion a year). Problems: high administrative cost, bankruptcy by suppliers (Delphi), quality control uneven Problems: high administrative cost, bankruptcy by suppliers (Delphi), quality control uneven Solution: multi-year contracts with fewer suppliers (down from 2,500 to 1,000); closer working relationship; estimated savings of 10% per year. Solution: multi-year contracts with fewer suppliers (down from 2,500 to 1,000); closer working relationship; estimated savings of 10% per year.

Many Forms of Contracts Services (Deere and Ryder Trucks; UPS and Toshiba warranty laptop repairs; UPS and Jockey; Japanese call centers in Dalien) Services (Deere and Ryder Trucks; UPS and Toshiba warranty laptop repairs; UPS and Jockey; Japanese call centers in Dalien) Joint Ventures (foreign firms in China) Joint Ventures (foreign firms in China) Leases (office buildings) Leases (office buildings) Franchises (McDonalds, car dealers) Franchises (McDonalds, car dealers) Strategic Alliances (Merck & Astra) Strategic Alliances (Merck & Astra)

Politics May Help Force Form McDonalds in Japan was run by politically well- connected Japanese company (JMcD). Toys “R” Us (Toys) wanted to enter Japan but bureaucrats stopped it. Alliance between JMcD and Toys: took care of politics and found natural benefits—JMcD knew the Japan real estate and customer market well. Every Toys store had JMcD in it. JMcD as profit partner had strong incentive to help Toys be successful.

Methods of Obtaining Inputs 3. Vertical Integration— (Non-market relations) When a firm chooses to produce an input internally rather than contract with outsiders. Benefits: Reduced opportunistic behavior by outsiders and fewer contracting costs. Problems: Lost specialization, locked into certain method of production, and increased organizational (managerial) costs. Inputs are usually highly specialized.

When Is Vertical Integration More Likely to Be Necessary? To protect brand name. Examples: Sony, Prada When there are specific assets or high sunk costs. Examples: pipeline; GM-Fisher; refinery. [Consider: Is it risky for an employee to become asset specific to a particular employer?] When economies of scale changes—Coke and Pepsi now own most bottling plants and control national marketing strategy. When coordination critical: stages of health care.

Multiple Forms May Exist About 20% of gasoline in U.S. is sold at stations owned by refiners (this share growing). Other 80% of gasoline sold by other companies. Why not all one way or the other? Refiners control retail price at their stations, but cannot control independents—can prevent price gouging by independents. Company owned stores tend to be huge stations not offering repair services or other specialized services done better by independents who will work to protect their personal reputation.

Forward or Backward Integration Forward—A company that owns a coal mine builds a power plant to generate electricity. Backward—An electric company buys a coal mine to guarantee supply. When the two are close to each other—usually integrate into one firm. Specific investments— boiler design tied to coal type. When utility not near coal mine; long term contracts with suppliers usually relied upon. Why not short term or spot contract?

Integration in Insurance Industry Whole life often sold through in-house sales force. The company holds the key asset (list of clients). To get agents to work hard the commissions are frontloaded—big at time of first sale. Fire and casualty insurance usually sold through independent brokers. The brokers hold the key assets (list of clients). To keep them tied to insurance company, the commissions are backloaded—renewal commission every year.

Methods of Obtaining Inputs Summary: Are there specialized investments relative to contracting costs? If no—likely to use spot market. If yes—is the cost of contracting high relative to the cost of integration? If yes—vertical integration; if no—contracts with outside suppliers. Think about chickens (or spinach).