CHAPTER 6 THE ORGANIZATION OF THE FIRM

Three methods of acquiring inputs:

Spot exchange occurs when the buyer and seller of an input meet, exchange, and then go their separate ways.
 An informal relationship between a buyer and seller in which neither party is obligated to adhere
to specific terms for exchange.
 A key advantage of acquiring inputs with spot exchange is that the firm gets to specialize in doing
what it does best: converting the inputs into output. The input manufacturer specializes in what it
does best: producing inputs. Spot exchange often is used when inputs are “standardized.”

A contract is a legal document that creates an extended relationship between a particular buyer and seller of an
input. It specifies the terms under which they agree to exchange over a given time horizon.
 A formal relationship between a buyer and seller that obligates the buyer and seller to
exchange at terms specified in a legal document.
 By acquiring inputs with contracts, the purchasing firm enjoys the benefits of specializing
in what it does best because the other firm actually produces the inputs the purchasing firm needs.
This method of obtaining inputs works well when it is relatively easy to write a contract that describes
the characteristics of the inputs needed. One key disadvantage of contracts is that they are costly to
write; it takes time, and often legal fees, to draw up a contract that specifies precisely the obligations
of both parties. Also, it can be extremely difficult to cover all the contingencies that could occur in the
future. Thus, in complex contracting environments, contracts will necessarily be incomplete.

Finally, a manager may choose to produce the inputs needed for production within the firm.
 VERTICAL INTEGRATION. A situation where a firm produces the inputs required to make its final
product.

The transaction costs of acquiring an input are the costs of locating a seller of the input, negotiating a
price at which the input will be purchased, and putting the input to use.

A specialized investment is simply an investment in a particular exchange that cannot be recovered in

another trading relationship. An 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.

Types of Specialized Investments

Site specificity occurs when the buyer and the seller of an input must locate their plants close to
each other to be able to engage in exchange.
Physical-asset specificity refers to a situation where the capital equipment needed to produce an
input is designed to meet the needs of a particular buyer and cannot be readily adapted to
produce inputs needed by other buyers.
Dedicated assets are general investments made by a firm that allow it to exchange with a
particular buyer.
A fourth type of specialized investment is human capital. In many employment relationships,
workers must learn specific skills to work for a particular firm. If these skills are not useful or
transferable to other employers, they represent a specialized investment.

Specialized investments increase transaction costs because they lead to

(1) costly bargaining,
(2) underinvestment,
(3) opportunism.

Solutions to the Manager–Worker Principal–Agent Problem

PROFIT SHARING
- Mechanism used to enhance workers’ efforts that involves tying compensation to the
underlying profitability of the firm
REVENUE SHARING
- Mechanism used to enhance workers’ efforts that involves linking compensation to the
underlying revenues of the firm.
- Revenue sharing is particularly effective when worker productivity is related to revenues rather than
costs
- One problem with revenue-based incentive schemes is that they do not provide an incentive for
workers to minimize costs.
PIECE RATE
- An alternative compensation method is to pay workers based on a piece rate rather than on a fixed
hourly wage
- A potential problem with paying workers based on a piece rate is that effort must be expended in
quality control; otherwise, workers may attempt to produce quantity at the expense of quality. One
advantage of revenue or profit sharing is that it reduces the incentive to produce low-quality products.
Lower quality reduces sales, thus reducing compensation to those receiving revenue- or profit-sharing
incentives.

SUMMARY POINTS!!!
1. The manager must decide which inputs will be purchased from other firms and which inputs
the firm will manufacture itself.
2. Spot exchange generally is the most desirable alternative when there are many buyers and
sellers and low transaction costs.
3. It becomes less attractive when substantial specialized investments generate opportunism,
resulting in transaction costs associated with using a market.
4. When market transaction costs are high, the manager may wish to purchase inputs from a
specific supplier using a contract or, alternatively, forgo the market entirely and have the firm set
up a subsidiary to produce the required input internally.
5. In a fairly simple contracting environment, a contract may be the most effective solution. But
as the contracting environment becomes more complex and uncertain, internal production
through vertical integration becomes an attractive managerial strategy.
6. Rewards must be constructed so as to induce the activities desired of workers.
7. If it is desirable to produce a high level of output with very little emphasis on quality, piece-
rate pay schemes work well.
8. However, if both quantity and quality of output are concerns, profit sharing is an excellent
motivator.