1. The Organization of the Firm
Chapter 6
The Organization of the Firm
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Methods of procuring inputs Transaction costs
Chapter Overview
Chapter Outline
Methods of procuring inputs
Purchase inputs using spot exchange
Acquire inputs under a contract
Produce inputs internally
Transaction costs
Types of specialized investments
Implications of specialized investments
Optimal input procurement
Spot exchange
Contracts
Vertical integration
Economic tradeoff
Managerial compensation and the principal-agent problem
Forces that discipline managers
Incentive contracts
External incentives
Manager-worker principal-agent problem
Solutions to the manager-worker principal-worker problem

3. Chapter Overview
Introduction
Chapter 5 focused on how to select the mix of inputs that minimizes the cost of production.
This chapter addresses the following two questions:
What is the optimal way to acquire the efficient mix of inputs?
How can owners of a firm ensure that workers put forth maximum effort consistent with their capabilities?

4. Management’s Role Introduction Producing at Minimum Cost Minimum Costs
($)
Minimum
cost function A
$100 B
$80
Output 10

5. Methods of Procuring Inputs
Spot market
An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific exchange.
Contract
A formal relationship between a buyer and seller that obligates the buyer and seller to exchange at terms specified in a legal document.
Produce inputs internally (vertical integration)
A situation where a firm produces the inputs required to make its final product.

6. Methods of Procuring Inputs In Action
Determine whether the following transactions involve spot exchange, a contract, or vertical integration:
Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next 3 years from AML. The price paid in the first year is $200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years.
Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine.
Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.
Answers:
Clone 1 PC is using a contract.
Clone 2 PC used the spot exchange.
Clone 3 PC uses vertical integration.

7. Transaction Costs
Transaction Costs
Cost associated with acquiring an input that is in excess of the amount paid to the input supplier.
Types of “obvious” transaction costs
Cost of searching for a supplier.
Cost of negotiating a price.
Investments and expenditures required to facilitate exchange.

8. Types of “Hidden” Transaction Costs
Specialized investment
Expenditure that must be made to allow two parties to exchange but has little or no value in any alternative use.
Relationship-specific exchange
A type of exchange that occurs when the parties to a transaction have made specialized investments.

9. Types of Specialized Investments
Transaction Costs
Types of Specialized Investments
Types of specialized investments
Site specificity.
Physical-asset specificity.
Dedicated assets.
Human capital.

10. Implications of Specialized Investments
Transaction Costs
Implications of Specialized Investments
Implications of specialized investments
Costly bargaining.
Underinvestment .
Opportunism and the “hold-up problem.”

11. Optimal Input Procurement
How should a manager acquire inputs to minimize costs?
Depends on the extent of the relationship-specific exchange.

12. Spot Exchange Characteristics of the spot exchange:
Optimal Input Procurement
Spot Exchange
Characteristics of the spot exchange:
No relationship-specific investment.
Absence of transaction costs, and many buyers and sellers, imply that the market price is determined by the intersection of demand and supply.
Opportunism.
Underinvestment in specialized investments.

13. Contracts Characteristics of contracts:
Optimal Input Procurement
Contracts
Characteristics of contracts:
Use when inputs require a substantial specialized investment.
Typically requires substantial up-front expenditures.
Specifies prices of inputs prior to making specialized investments.
Reduces likelihood of opportunism.
Reduces likelihood to skimp on specialized investment.
Requires decision on optimal contract length.

14. Optimal Contract Length In Action
Optimal Input Procurement
Optimal Contract Length In Action
MB, MC
($) MC MB
𝐿 ∗
Contract Length
(in years)

15. Specialized Investments and Contract Length In Action
Optimal Input Procurement
Specialized Investments and Contract Length In Action
MB, MC
($) MC
MB1
Greater need for
specialized investment
MB0
𝐿 0
𝐿 1
Contract Length
Longer contract

16. Specialized Investments and Contract Length In Action
Optimal Input Procurement
Specialized Investments and Contract Length In Action
MC1
MC0
MC2
MB, MC
($)
More complex
contracting
environment
Less complex
contracting
environment MB
𝐿 1
𝐿 0
𝐿 2
Contract Length
Shorter contract
Longer contract

17. Vertical Integration Produce inputs internally.
Optimal Input Procurement
Vertical Integration
Produce inputs internally.
Use when inputs require
a substantial specialized investment.
generate significant transaction cost.
complex contracting or uncertain economic environments.
Advantages:
“Skips the middleman.”
Reduces opportunism.
Mitigates transaction costs.
Disadvantages:
Managers must create an internal regulatory mechanism.
Bear the cost of setting up production facilities.
No longer specialized in producing its output.

18. The Economic Trade-Off
Optimal Input Procurement
The Economic Trade-Off
Substantial specialized investment relative to contracting costs?
Spot exchange
Complex contracting environment relative to cost of vertical integration
Contract
Vertical integration

19. Compensation and the Principal-Agent Problem
Managerial Compensation and the Principal Agent Problem
Compensation and the Principal-Agent Problem
Having learned about the principal factors in selecting the best methods of acquiring inputs, we now explain how to compensate labor inputs to put forth maximal effort.
The primary obstacle is the separation of ownership and control.
Principal-agent (P-A) problem leads to the following question: Is poor performance due to
back luck?
low manager effort?
Owners have to incent managers since they are not present to monitor.

20. Managers’ Compensation Mechanisms
Managerial Compensation and the Principal Agent Problem
Managers’ Compensation Mechanisms
Manager’s economic trade-off
Leisure.
Labor.
Fixed salary
Receives wage independent of labor hours and effort.
No strong incentive to monitor other employees labor hours and effort.
Adversely impacts firm performance.
Incentive contract
Tie manager wage to firm performance (like profits).
Manager makes labor-leisure choice and is accordingly compensated.

21. Forces that Discipline Managers
Incentive Contracts
A way to align owners’ interests with that of the actions of its manager.
Examples include:
Stock option
Other bonuses directly related to profits.

22. Forces that Discipline Managers
External Incentives
Outside forces can provide manages with the incentive to maximize profits, and include:
Reputation.
Takeover threat.

23. The Manager-Worker Principal-Agent Problem
The owner-manager, principal-agent problem is not unique.
A similar problem exists between the firm’s managers and the employees he or she supervises.

24. Solutions to the Manager-Worker Problem
The Manager-Worker Principal-Agent Problem
Solutions to the Manager-Worker Problem
Manager-worker principal-agent problem solutions:
Profit sharing.
Revenue sharing.
Piece rates.
Time clocks and spot checks.

25. Conclusion
The optimal method for acquiring inputs depends on the nature of the transaction costs and specialized nature of the inputs being produced.
To overcome the owner-manager and manager-worker principal-agent problems, principals must align the agents’ interests with the principals’ interests.

26. Management’s Role Introduction Minimum Costs cost function ($) A $95 B
$75
Output
150