The Organization of the Firm

Chapter 6

Course outline

demand Basic Model Cost/Market structure Managerial perspective Organization of firm

Managerial Microeconomics markets

Marginal analysis
Strategic analysis

Additional topics

Applying economics Methodology Matching thoery

Overview
I. Methods of Procuring Inputs

Spot Exchange Contracts Vertical Integration Specialized Investments

II. Transaction Costs

III. Optimal Procurement Input

I. Methods of Procuring Inputs

Spot Exchange

When the buyer and seller of an input meet, exchange, and then go their separate ways.

Contracts

A legal document that creates an extended relationship between a buyer and a seller. When a firm shuns other suppliers and chooses to produce an input internally.
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Vertical Integration

II. Transaction Costs

Costs of acquiring an input over and above the amount paid to the input supplier. Includes: Search costs. None in perfectly competitive market, due to complete information Negotiation costs. None in perfectly competitive market, due to perfect competition (all are price takers). Other required investments or expenditures. Explains why sometimes contracts/ownership is better than market (spot exchange).
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II. Specialized Investments

Some transactions are general in nature while others are specific to a trading relationship. Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship. Examples:

Electric power plants located close to a particular coal mine A company invests in a production line to produce chassis for Toyota. A worker has to learn and adapt to the firms culture. A firm has to train the worker.

Specialized investments not enough competition

II. Specialized investments

Lead to higher transaction costs (or market failure)

Costly bargaining

due to lack of alternative input suppliers (hence lack of competition) and the lack of alternative use of specialized investment (hence possible hold-up problem). Of specialized investment: not specific enough production line. Once a firm made a specialized equipment, the other party may take advantage of the fact that the cost of the specialized equipment is sunk.

Underinvestment.

Opportunism and the hold-up problem.

III. Optimal Input Procurement

No
Spot Exchange

Substantial specialized investments relative to Yes contracting costs?

Complex contracting environment relative to costs of integration?

Yes

No

Contract

Vertical Integration
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Topic Intended Learning Outcomes

7.1 Analyze every decision makers incentive under different scenarios (such as different contracts, ownership structure.) 7.2 Understand decision-makers available options and sensibly evaluate each option. 7.3 Analyze when contracts work well and when it may not work well. 7.4 Understand the benefit and cost of ownership.
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Topic Intended Learning Outcomes

7.5 Define and give examples of specialized investments, and the possible transaction cost related to specialized investments. 7.6 Explain the optimal manner of procuring inputs under different circumstances.

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