Wk8 DQ - Managerial Eonomics

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The Organization of the Firm

Chapter 6

Learning Objective

Discuss the economic trade-offs associated with obtaining inputs through spot exchange, contract, or vertical integration.

Identify four types of specialized investments, and explain how each can lead to costly bargaining, underinvestment, and/or a “hold-up problem.”

Explain the optimal manner of procuring different types of inputs.

Describe the principle-agent problem as it relates to owners and managers.

Discuss three forces that owners can use to discipline managers.

Describe the principal-agent problem as it relates to managers and workers.

Discuss four tools the manager can use to mitigate incentive problems in the workplace.

Management’s Role

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Output

Costs

($)

Minimum

cost function

$80

$100

Introduction

Producing at Minimum Cost

Methods of Procuring Inputs

Spot exchange

An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific terms for 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.

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Methods of Procuring Inputs

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.

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Methods of Procuring Inputs

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.

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Transaction Costs

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.

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Transaction Costs

Types of Specialized Investments

Types of specialized investments

Site specificity

Physical-asset specificity

Dedicated assets

Human capital

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Transaction Costs

Implications of Specialized Investments

Implications of specialized investments

Costly bargaining

Underinvestment

Opportunism and the “hold-up problem”

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Transaction Costs

Optimal Input Procurement

How should a manager acquire inputs to minimize costs?

Depends on the extent of the relationship-specific exchange.

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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

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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.

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Optimal Input Procurement

Optimal Contract Length

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Contract Length

(in years)

MB, MC

($)

Optimal Input Procurement

Specialized Investments and Contract Length

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Contract Length

MB, MC

($)

MB0

MB1

Longer contract

Greater need for

specialized investment

Optimal Input Procurement

Contracting Environment and Contract Length

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Contract Length

MB, MC

($)

MC0

Shorter contract

More complex

contracting

environment

MC1

MC2

Longer contract

Less complex

contracting

environment

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

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Optimal Input Procurement

Optimal Procurement of Inputs

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Optimal Input Procurement

Managerial Compensation and the Principal-Agent Problem

The primary obstacle is the separation of ownership and control.

Principal-agent (P-A) problem: if the owner is not present to monitor the manager, how can she get the manager to do what is in her best interest?

Owners have to incent managers since they are not present to monitor.

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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.

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Managerial Compensation and the Principal Agent Problem

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.

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Forces that Discipline Managers

External Incentives

Outside forces can provide manages with the incentive to maximize profits, and include:

Reputation

Takeover threat

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Forces that Discipline Managers

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.

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The Manager-Worker Principal-Agent Problem

Solutions to the Manager-Worker Principal-Agent Problem

Manager-worker principal-agent problem solutions:

Profit sharing

Revenue sharing

Piece rates

Time clocks and spot checks

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The Manager-Worker Principal-Agent Problem

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.

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