Eco

ECO 2301, Principles of Microeconomics 1

Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:

1. Discuss the central economic problem.

2. Describe how supply and demand can affect an economy.

3. Discuss types of economic market structures.

4. Explain factors that influence decision-making by consumers and producers. 4.1 Identify why firms exist. 4.2 Identify factors that can create a situation where vertical integration is desirable. 4.3 Describe why firms would use outsourcing.

5. Recall the theories of economic regulation.

Course/Unit Learning Outcomes

Learning Activity

1 Unit VII Final Project

2 Unit VII Final Project

3 Unit VII Final Project

4.1 Unit Lesson Chapter 11 Unit VII Final Project

4.2

Unit Lesson Chapter 14 Webpage: The Interesting Case of the Vertical Merger Unit VII Final Project

4.3

Unit Lesson Chapter 14 Article: “Lessons Learned From Offshore IT Outsourcing: A Client and Vendor

Perspective” Webpage: 10 Small Business Functions That Can Be Easily Outsourced Unit VII Final Project

5 Unit VII Final Project

Required Unit Resources Chapter 11: Resource Markets Chapter 14: Transaction Costs, Asymmetric Information, and Behavioral Economics In order to access the following resources, click the links below. Campbell, A. (2019, November 19). 10 small business functions that can be easily outsourced. U.S. Small

Business Administration. https://www.sba.gov/blog/10-small-business-functions-can-be-easily- outsourced

UNIT VII STUDY GUIDE

Decision-Making, Product Integration, and Outsourcing

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Haried, P., & Ramamurthy, K. (2010). Lessons learned from offshore IT outsourcing: A client and vendor perspective. Journal of Information Technology Case & Application Research, 12(1), 12–38. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=tsh&AN=49119595&site=ehost-live&scope=site

Sallet, J. (2016, November 17). The interesting case of the vertical merger [Prepared remarks]. American Bar

Association Fall Forum, Washington, DC, United States. https://www.justice.gov/opa/speech/file/938236/download

Unit Lesson

Why Do Firms Exist? As we enter the last units of the class, we come to a question in economics, which is “Why do firms exist?” The answer is that it is more efficient to organize activities through a firm than for consumers to try and engage in all the transactions it would take to consolidate all the resource suppliers (McEachern, 2019). For example, if your family was growing, and you needed a larger house, you could find the suppliers of the concrete to pour the foundation, of wood to make the frame, of flooring to lay the carpet and tile, and all the other resource suppliers to provide the inputs necessary to build the house. McEachern (2019) suggests that building a house in this way would require that you incur the cost of:

• deciding what inputs to use and how to use them correctly and

• reaching an agreement with the resource providers to provide their specific services. The costs associated with painting your new house may be easy to identify and calculate. The cost of the brushes, paint, and labor are easily calculated. The costs of identifying and negotiating the appropriate inputs can get high when it comes to plumbing, electrical, and other highly technical aspects of building the house. McEachern (2019) suggests that the choice of incurring these costs or hiring a firm to perform these tasks depends on the individual consumer’s skill and opportunity cost of time. Even something as simple as mowing your lawn is based on these two factors. Some consumers may have the skill to mow their lawn, but the opportunity cost of their time is extremely large. In this instance, the consumer will hire a firm to mow their lawn. In another instance, an individual’s opportunity cost of time is low, but they may not own a lawnmower or have the skill or physical capability to mow their lawn. Again, in this instance, the individual will hire a firm to perform the task. The firm that provides the lawn mowing service exists because they minimize the transaction costs and production costs associated with the activity of mowing the lawn (McEachern, 2019). Now that we know why the firm exists, the next question becomes what the efficient boundaries of the firm are. Boundaries of the firm means the degree of vertical integration. Vertical integration means the expansion of the firm into stages of production either earlier or before the point where the firm specializes (McEachern, 2019). For example, Netflix introduced the ability to watch television shows and movies through a streaming service in 2007 (Netflix Media Center, n.d.). These television shows were first created and then offered through the service provided by Netflix. By 2012, Netflix realized it could earn higher revenues by expanding its business to include the creation of original content. That means Netflix vertically integrated backward to include creating the content that it offered to viewers. Microsoft is another example of a firm that has vertically integrated. Microsoft (2020) was founded as a firm that developed software that computers used as operating systems. However, in 2001, Bill Gates demonstrated a prototype of Microsoft’s Tablet PC. In this instance, Microsoft integrated forward to provide not only the software technology but also the hardware. Another form of integration is horizontal. Horizontal integration occurs when one firm increases production of a good or service through internal expansion, acquisition of another firm, or a merger with another firm within the same industry that offers the same level of product or service (McEachern, 2019). An example of horizontal integration is Pixar and Disney. Pixar began working with Disney in 1986 producing short animated films, and Disney formally purchased Pixar in 2006 (Pixar, n.d.). Both Disney and Pixar were in the business of creating short animated films. In other words, they occupied the same level of supply of the good. The

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purchase of Pixar by Disney represented a horizontal integration of the good as it expanded Disney’s production capacity. Another way firms can obtain resources is through outsourcing. Outsourcing occurs when a firm purchases products from another firm (McEachern, 2019). Outsourcing allows firms to focus on what they do best. For example, Mrs Baird’s specializes in making bread. Attempting to grind their own flour from wheat to use in the bread would be outside the core competencies of Mrs Baird’s. Thus, Mrs Baird’s outsources the production of flour to other companies. Likewise, Best Maid Pickles specializes in producing various kinds of pickles. It would be outside the core competencies of Best Maid Pickles to attempt to grow its own cucumbers to make the pickles, so Best Maid Pickles outsources cucumber production. McEachern (2019) suggests that internal production and making purchases in the market are alternative ways of organizing transactions. The decision of whether to produce a product internally or outsource production depends on the most efficient way to carry out the transaction.

How Do Managers Do It? Managers must put together a puzzle of production. Very important pieces of that puzzle are the prices of all the inputs used in the production process. McEachern (2019) suggests that the decisions that must be made by mangers become greater as the firm becomes more vertically integrated. For example, Steve Jobs only had a brief background in designing video games for Atari Corporation before teaming up with Steve Wozniak (Levy, n.d.). What Jobs understood was that the personal computer would appeal to consumers. The creation of the coding and hardware was left to Wozniak. Jobs saw the market demand and knew how to market the idea. Effectively, Steve Jobs could sell a drowning man a drink of water, but he knew little about the development and design of the computer itself. As Apple began mass-producing computers, the distance between Steve Jobs and the day-in and day-out design and production became greater and greater. Think about it. There were programmers developing code. There were factories producing the computer cases, keyboards, and monitors. There were salespersons connecting with stores. What had started as an intimate relationship between design, development, and creation between Steve Jobs and Steve Wozniak in their garage had evolved into a complex system. As firms become vertically integrated, a manager’s ability to comprehend information about a firm’s operation becomes more and more limited. These limits on the ability of the manager to comprehend information is referred to as bounded rationality (McEachern, 2019). The solution can be for the firm to reduce the functions it performs to its core competencies and to outsource the production of inputs that are outside of these core competencies.

To Outsource or Not to Outsource, That Is the Question When a firm is attempting to determine whether to outsource production of a good or to produce it internally, the firm will examine whether the quality of the good can be determined. McEachern (2019) suggests that firms will purchase inputs in the market if the quality can be determined easily at the time of purchase. McEachern uses an example of a flour mill purchasing wheat in the market rather than growing its own wheat. The quality of wheat can be easily determined by inspecting it. However, the quality of the flour itself is the foundation company’s reputation. The quality of flour cannot be easily determined without constant analysis during the production process. That is why flour mills will outsource the production of wheat. It may also surprise you that large fast food chains such as Kentucky Fried Chicken (KFC) and McDonald’s outsource the production of items such as their chicken nuggets. When you visit a KFC or McDonald’s, the chicken nuggets you order have been produced and even precooked using the secret recipes at a processing plant owned and operated by Tyson, Pilgrim’s Pride Chicken, and others. The fast food restaurant receives the pre-cooked chicken nuggets and only heats them up before serving them to you. The reason these fast food restaurants do this is because it is easy for them to evaluate the quality of each shipment of chicken

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nuggets at the point of purchase. Furthermore, it would be far less cost-effective for each fast food restaurant to cut the nuggets and bread and fry them for each order. In the end, the decision to outsource products or vertically integrate is normally based on the number of suppliers (McEachern, 2019). If the number of suppliers is extremely large, firms will usually just outsource goods rather than produce it themselves. An abundance of suppliers ensures ample product and a consistent quality. This is why fast food restaurants outsource the production of chicken as well as of the chicken nuggets themselves. If a firm cannot rely on consistent supplies, they will tend to make it themselves.

Economies of Scope Have you ever sat back and thought about the wide range of products Apple, Inc. produces? Apple, Inc. produces operating systems, software, computers, the iPhone, AirPods, and the list goes on and on. Apple, Inc. has found that it is cheaper to produce more different items than to produce them by separate firms. This is the definition of economies of scope (McEachern, 2019). With economies of scope, the average cost per unit is lower as the firm produces more types of products. Costs associated with the research and development of an iPad can be spread across the development of the iPhone. As you look around you at the world, think about firms that have vertically integrated. Do you notice differences in the quality of goods and services that are offered after the integration? Do you think that the price of the final product is lower after the vertical integration? Also, consider firms that have branched out and are now offering different items for sale. Are these firms effectively capturing economies of scope? It is fascinating to examine the world around us and consider why firms behave the way they do. Your economics classroom is happening all around you, all the time. Take the knowledge you have gained so far in this class and not only grade the success of actions of firms but also ask the question of why firms are behaving the way they do.

References Levy, S. (n.d.). Steve Jobs: American businessman. In Encyclopaedia Britannica. Retrieved June 25, 2020,

from https://www.britannica.com/biography/Steve-Jobs McEachern, W. A. (2019). Micro ECON6: Principles of microeconomics. Cengage Learning.

https://online.vitalsource.com/#/books/9781337671828 Microsoft. (2020). Facts about Microsoft. https://news.microsoft.com/facts-about-microsoft/ Netflix Media Center. (n.d.). Netflix timeline. https://media.netflix.com/en/about-netflix Pixar. (n.d.). Our story. https://www.pixar.com/our-story-pixar