Organization of Firm

Learning Objectives: How do firms hire inputs of production? What are transaction costs? What is the Principal-Agent problem?

How can a firm hire inputs? Spot Exchange: Purchasing inputs as requirements arise, without any continual obligation Contract: Legally binding continual exchange between the firm and the input suppliers Vertical Integration: Production of inputs internally

Transaction Costs Transaction Costs are the excess costs incurred for acquiring inputs other than the prices of inputs. Two types: Search cost Matching cost

Specialized Investment and relationship-specific Exchange Specialized investments are non-transferable investments to facilitate a relationship-specific exchange Types of specialized investments Site specificity Physical asset specificity Dedicated assets Human capital

Specialized Investments and Transaction Costs Costly Bargaining Underinvestment Opportunism

Optimal Input Procurement It is firm specific and depends on the features of a particular production process, legal environment, and overall economic situation. Example: ATMs and a Rising Number of Bank Tellers? Example: Outsourcing at Ericsson

Principal-Agent Problem When ownership is separated from control, how do the owners monitor their employees, and ensure that they are putting the maximum effort? How does a manager ensure that employees are not shirking? Solution: Devise an incentive mechanism Example: Jack Welch and General Electric