CHAPTER 1 - OVERVIEW

ACCOUNTING PROFITS - ECONOMIC PROFITS

Accounting Profits Economic Profits

Total revenue (sales) minus the dollar cost Total revenue minus the total opportunity
of producing goods or services. cost

AP = TR – IC (explicit) EP = TR – TC
= TR - (IC + OC) (explicit + implicit)

Not count the opportunity cost Count the opportunity cost (implicit cost)

The explicit costs of the resources needed

to produce goods or services and
reported on the firm’s income Statement
Note:
● Explicit costs are out-of-pocket costs for a firm—for example, payments for wages
and salaries, rent, or materials.
● Implicit costs are a specific type of opportunity cost: the cost of resources already
owned by the firm that could have been put to some other use. For example, an
entrepreneur who owns a business could use her labour to earn income at a job
● Opportunity costs: The cost of the explicit and implicit resources that are foregone
when a decision is made.

Exercise 1:
Suppose you own a building in New York that you use to run a small pizzeria. Food
supplies are your only accounting costs. At the end of the year, your accountant informs
you that these costs were $20,000 and that your revenues were $100,000. Thus, your
accounting profits are $80,000. Economic profits?
Answer:
Explicit cost = Implicit cost = $20,000
Economic profit = Total revenue - Total cost = 100,000 - (20,000 + 20,000) = $60,000

PRESENT VALUE
Present value: The amount that would have to be invested today at the prevailing interest
rate to generate the given future value.
Present value analysis is useful in determining the value of a firm since the value of a firm
is the present value of the stream of profits (cash flows) generated by the firm’s physical,
human, and intangible assets.

i: the rate of
interest, or the opportunity cost of funds
Net present value: The present value of the income stream generated by a project minus
the current cost of the project.
Value of a perpetual bond (trái phiếu định kỳ) that pays the owner $xxx at the end of
each year (FV/i)/ different $xxx at the respective year.
If π0 is the firm’s current level of profits, π1 is next year’s profit, and so on, then the value
of the firm is:

Exercise 2:
The manager of Automated Products is contemplating the purchase of a new machine
that will cost $300,000 and has a useful life of five years. The machine will yield (year-end)
cost reductions to Automated Products of $50,000 in year 1, $60,000 in year 2, $75,000 in
year 3, and $90,000 in years 4 and 5. What is the present value of the cost savings of the
machine if the interest rate is 8%? Should the manager purchase the machine?
Answer:
● Solution 1: PV = 300,000/(1+0.08)^5 = 204,174.96 < 300,000
=> Because the present value of the cost savings of the machine is lower than the
price of the machine, the manager should not purchase the machine.
● Solution 2: NPV = 50,000/1.08 + 60,000/1.08^2 + 75,000/1.08^3 + 90,000/1.08^4 +
90,000/1.08^5 - 300,000 = -15.321 < 0
=> Because the net present value of the cost savings of the machine is smaller than
0 (negative), the manager should not purchase the machine.

Exercise 3:
An owner can lease her building for $120,000 per year for three years. The explicit cost of
maintaining the building is $40,000, and the implicit cost is $55,000. All revenues are
received, and cost borne, at the end of each year. If the interest rate is 5 percent,
determine the present value of the stream:
Answer:
● Accounting profits = 120,000 - 40,000 = 80,000
PV (accounting profits) = 80,000/(1.05 + 80,000/1.05^2 + 80,000/1.05^3 = 217,859.84
● Economic profits = 120,000 - (40,000 + 55,000) = 25,000
PV (economic profits) = 25,000/1.05 + 25,000/1.05^2 + 25,000/1.05^3 = 68,081.20

MAXIMIZE PROFITS
MARGINAL PRINCIPLE:
To maximize net benefits, the manager should increase the managerial control variable
up to the point where marginal benefits equal marginal costs. This level of the
managerial control variable corresponds to the level at which marginal net benefits are
zero; nothing more can be gained by further changes in that variable. MB = MC ; MNB = 0
MARGINAL ANALYSIS:
The examination of the costs and benefits of a marginal (small) change in the production
of goods

● MB > MC increased benefits more than it increased costs (deltaB>deltaC) => Move
Ahead
● MB < MC increased costs more than it increased benefits. (deltaB<deltaC) => Scale
Back
● Net Benefits = Total Benefits - Total Costs
● Profits = Revenue - Costs
● Marginal (incremental) benefit (MC): Change in total benefits arising from a
change in the control variable Q; Slope (calculus derivative) of the total benefit
curve MB = B’(Q)
● Marginal (incremental) cost (MC): Change in total costs arising from a change in
the control variable Q; Slope (calculus derivative) of the total cost curve MC = C’(Q)
● Marginal net benefits: MNB = MB − MC
 ● Marginal benefit: MB = deltaB / deltaQ
● Slope (calculus derivative) of total benefit (TB) curve.
● Marginal cost: MC = deltaC / deltaQ
● Slope (calculus derivative) of total cost (TC) curve

Exercise 4:
An engineering firm recently conducted a study to determine its benefit and cost
structure. The results of the study are as follows: B (Y)  = 300Y − 6 Y^2 ; C (Y)  = 4Y^2. The
manager has been asked to determine the maximum level of net benefits and the level of
Y that will yield that result.
Answer:
MB(Y) = B’(Y) = 300 - 12Y ; MC(Y) = C’(Y) = 8Y
To maximize benefits: MB = MC => 300 - 12Y = 8Y => Y* = 15

INCREMENTAL DECISIONS
● Sometimes managers are faced with proposals that require a simple thumbs-up or
thumbs-down decision (yes-or-no decisions)
● Adopt project when incremental revenues exceed incremental costs
● Incremental revenues: The additional revenues that stem from a yes-or-no
decision.
● Incremental costs: The additional costs that stem from a yes-or-no decision.
● When IR > IC, you should adopt that project.

Exercise 5:
To illustrate, imagine that you are the CEO of Slick Drilling Inc. and you must decide
whether or not to drill for crude oil around the Twin Lakes area in Michigan. You are
relatively certain there are 10,000 barrels of crude oil at this location. An accountant
working for you prepared the information in the table below to help you decide whether
or not to adopt the new project.
Answer: We should adopt the new project because the Incremental revenues exceed the
Incremental costs ($183,200 > $165,000) and the profits are positive.

Exercise 6:
On Tuesday, software giant Amcott posted a year-end operating loss of $3.5 million.
Reportedly, $1.7 million of the loss stemmed from its foreign language division. With
short-term interest rates at 7%, Alcott decided to use $20 million of its retained earnings
to purchase three-year rights to Magic word, a software package that converts generic
word processor files saved as French text into English. First-year sales revenue from the
software was $7 million, but thereafter sales were halted pending a copyright
infringement suit filed by Foreign, Inc. Amcott lost the suit and paid damages of $1.7
million. Industry insiders say that the copyright violation pertained to “a very small
component of Magic word.” Ralph, the Amcott manager who was fired over the incident,
was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their
homework before buying the rights to Magic word. I projected annual sales of $7 million
per year for three years. My sales forecasts were right on target.” Do you know why Ralph
was fired?
Answer:
Ralph was fired because he forgot to calculate the net present value of the project. The
total revenue should be $21 million in three years. He failed to consider the NPV of a
project to be able to make decisions related to this, which means he was not competent
enough. Therefore, he was fired.
 CHAPTER 2 - DEMAND ANALYSIS, ESTIMATION & FORECASTING
PRICE ELASTICITY OF DEMAND (E) & MARGINAL REVENUE
● Measures responsiveness or sensitivity of consumers to changes in the price of a
good
=> The changes to the quantity demanded when price changes.

● The larger the absolute value of E, the more sensitive buyers are to a change in
price
● => The buyers may reduce their purchase of products
○ RELATIVELY ELASTIC (|E| > 1; |%deltaQ| > |%deltaP|: As price changes, there
is a LARGE change in quantity demanded for a good or service.
If the demand price is elastic, with an increase in price, there is a large
fall in sales so that the total rev­enue decreases. On the other hand, if
the price falls, the sales increase so much that the total revenue rises.
○ RELATIVELY INELASTIC (|E| < 1; |%deltaQ| < |%deltaP|: As price changes,
there is a SMALL change in quantity demanded for a good or service
If the demand price is inelastic, the sales will fall with the increase in
price but the total revenue will rise. On the other hand, with the fall in
price, the sales will increase but the total revenue will fall. For essential
consumption with the unique supply (electricity, water). If the price
increase, the consumption would not change because there are no
substitutes for these suppliers
○ UNIT ELASTICITY (|E| = 1; |%deltaQ| = |%deltaP|: As price changes, quantity
demand for a good or service will change by the same amount.
If the elasticity of demand is equal to unity, there is no change in total
revenue earned from sales even with the change in price.
● PERFECT ELASTICITY (unrealistic) If supply is perfectly elastic, it means that
any change in price will result in an infinite amount of change in quantity.
● PERFECT INELASTICITY (unrealistic): Quantity demanded remains the same
when the price increases or decreases. Consumers are completely
unresponsive to changes in price

● Price elasticity can be calculated by multiplying the slope of demand (Q/P) times
the ratio of price to quantity (P/Q)
 ● Given Q = a + bP where b = Q/P

Where P and Q are values of price and quantity demanded at the point of measure
along with demand, and A(=-a’/b) is the price intercept of demand.

Discussion 1:
You usually buy a cup of smoothie at the price of 20,000VNĐ at that store. One day, the
store increase the price to 100,000VNĐ per cup. Will you continue to buy smoothies at
that store, given that you really like smoothies there?
Answer:
It depends on the situation.
- I will stop buying smoothies at this store because it is an alternative. I can still buy
smoothies at other stores. A lot of substitutions
- I will continue to buy smoothies at this store if:
+ The market price increases due to external factors (pandemic, interrupt in the supply
chain, etc.)
+ The increase in price is due to the increase in quality.

Discussion 2:
Suppose that you go to work by motorbike. Suppose that the price of gasoline increases
by 10%. Do you still buy gasoline with an increase in price?
Answer:
I will still buy the gasoline with an increase in price because I have no other option.
➢ In the short term, although the price of gasoline increases, the demand for
gasoline will only decrease trivially because there is no substitute for gasoline.
➢ In the long term, if the price of gasoline continues to increase, people will find
other options, which leads to a substantial decrease in demand for gasoline.

Exercise 1:
The manager at Borderline Video Emporium faces the demand curve for Blu-ray DVD
discs shown in Figure 6.1. Predict and calculate the change in total revenue in the below
instances:
1. At the current price of $18 per DVD, Borderline can sell 600 DVDs each week. The
manager can lower the price to $16 per DVD and increase sales to 800 DVDs per
week. Over the interval, a to b on demand curve D the price elasticity is equal to
-2.43.
2. Now suppose the manager at Borderline is charging just $9 per compact disc and
sells 1,500 DVDs per week (see Panel B). The manager can lower the price to $7 per
disc and increase sales to 1,700 DVDs per week. Over the interval c to d on demand
curve D, the elasticity of demand equals -0.50.
From those results, what do you infer?
Answer:
1. E = -2.43 => |E| > 1, the demand curve is elastic.
Consumers are relatively sensitive to the change in price. A small increase in the
price will lead to a large decrease in the quantity demanded. When the price
decrease from $18 to $16, the quantity demanded increases from 600 to 800. The
total revenue will increase with the increase in the price.
2. E = -0.5 => |E| < 1, the demand curve is inelastic.
3. When the price decrease from $9 to $7, the quantity demanded increases from 1,500
to 1,700.
 ● Marginal revenue (MR) is the change in total revenue per unit change in output
● Since MR measures the rate of change in total revenue as quantity changes, MR is
the slope of the total revenue (TR) curve MR = TR’(Q)

DEMAND ESTIMATION & FORECASTING

● Q is quantity demanded
● P is the price of the good of service
● M is the consumer income
● PR is the price of some related good R.
TIME SERIES FORECAST
The simplest form is linear trend forecasting - Sales in each time period (Qt ) are
assumed to be linearly related to time (t)

LINEAR TREND FORECASTING

● If b > 0, sales are increasing over time

● If b < 0, sales are decreasing over time
● If b = 0, sales are constant over time
=> Statistical significance of a trend is determined by testing b^ or by examing the
p-value for b^.
DIRECT METHODS OF DEMAND ESTIMATION - COLLECTING DATA
➢ Consumer interviews
○ Range from stopping shoppers to speak with them to administering detailed
questionnaires
○ Potential problems
■ Selection of a representative sample, which is a sample (usually random)
having characteristics that accurately reflect the population as a whole
■ Response bias, which is the difference between responses given by an
individual to a hypothetical question and the action the individual takes
when the situation actually occurs
■ The inability of the respondent to answer accurately
➢ Market studies & experiments
 ○ Market studies attempt to hold everything constant during the study except
the price of the good
○ Lab experiments use volunteers to simulate actual buying conditions
○ Field experiments observe the actual behaviour of consumers

Exercise 2:
Specify price-setting firm’s demand function Q = a + bP + cM + dPAl + ePBMac
Where:
● Q = sales of pizza at Checkers Pizza
● P = price of a pizza at Checkers Pizza
● M = average annual household income in Westbury
● PAl = price of a pizza at Al’s Pizza Oven
● PBMac = price of a Big Mac at McDonald’s

1. Test the significance of estimated slope parameters? Is the model as the whole
significant?
t value = 1.96
The t value of the 4 models is larger than 1.96, which means the estimated slope
parameters are of significance.
2. Calculate the estimated demand elasticity at values of P, M, PAl, and PBmac where
P = 9.05, M = 26,614, PAl = 10.12, and PBMac = 1.15. Explain the result?
Q = 1092.106 – 123.185 + 0.091I + 109.973PAL + 67.447PBMac
b = -213.185 ; P = 9.05 ; Q = 355.7
E = b*P/Q = -5.424 => |E|>1 => The demand for pizza is elastic.

Exercise 3:
You are a division manager at Toyota. If your marketing department estimates that the
semiannual demand for the Highlander is Q = 150,000 - 1.5P, what price should you charge
in order to maximize revenues from sales of the Highlander?
Demonstration:
TR = P*Q <=> TR’=150,000 - 3P = 0
=> TR = P*(150,000 - 1.5P) <=> P = 50,000
=> TR = 150,000P - 1.5P2 => Q = 150,000 - 1.5*(50,000)
To maximize revenues from sales of the => Q = 75,000
Highlander
CHAPTER 3 - PRODUCTION & COSTS ANALYSIS - ORGANIZATION OF FIRM
3.1 PRODUCTION & COSTS ANALYSIS
Short Run Long Run

At least one input is fixed All inputs are variable

All changes in output are achieved by Output changed by varying usage of all
changing the usage of variable inputs inputs

Capital K is fixed
Only changes in the variable labour L
input can change the level of output

3.1.1. PRODUCTION & COSTS IN THE SHORT RUN

● Total product (Q) is the maximum output that can be produced by a certain level of
input
● Average product of labour AP = Q/L
● Marginal product of labour (L is the derivative) MP = Q/L
● When AP reaches its maximum: AP = MP
● Law of diminishing marginal product: As the usage of an input increases, the
marginal product initially increases (increasing marginal returns), then begins to
decline (decreasing marginal returns), and eventually becomes negative (negative
marginal returns).
1st phrase of productivity: 0-5: TP
increases with 1 unit of labor, MP > 0
and increasing => Increasing
marginal returns
2nd phrase of productivity: 5-10: TP
still increases but slower, reach
maximum at Labor = 10, MP > 0 and
decreasing => Decreasing
(Diminishing) marginal returns
3rd phrase of productivity: 10-n: TP
decreases, MP < 0 and decreasing
=> Negative marginal returns
At Labor = 7, APL = MPL. After this
point, TP starts to increases slowly
until it reaches its maximum level
and begins to decrease.

● Value marginal product: The value of the output produced by the last unit of an
input:

● Additional value that additional labour can bring to the firm

● As long as the value the labour brings to the firm (4) is higher than the cost to hire
him (5)
=> The manager should hire 9 labors (as (1), (4), (5): 516 > 400 and 228 < 400)
● Total variable cost (TVC)
○ Total amount paid for variable inputs
○ Increases as output increases
● Total fixed cost (TFC)
○ Total amount paid for fixed inputs
○ Does not vary with output
● Total cost (TC) TC = TVC + TFC
● Average variable cost AVC = TVC/Q
● Average fixed cost (AFC) decreases continuously as output increases, equal to the
vertical distance between ATC & AVC AFC = TFC/Q

● Average total cost

● Short-run marginal cost (SMC) measures the rate of change in total cost (TC) as

output varies SMC = TC’(Q) = TVC’(Q)

○ SMC, AVC, ATC are in U shape
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are falling: SMC < AVC: the firm stop
their business (shut down point)
○ Lies above AVC & ATC when AVC & ATC are rising
○ AVC < SMC < ATC

○ w is the price of the variable input

● MP (AP) increase, MC (AC) decrease
● MP (AP) decrease, MC (AC) decrease
● MP = AP at AP maximum
● MC = AC at AVC minimum
Exercise 1: Considering this illustration problem:
ACME Coal paid $5,000 to lease a railcar from the Reading Railroad. Under the terms of
the lease, $1,000 of this payment is refundable if the railcar is returned within two days of
signing the lease.
1. Upon signing the lease and paying $5,000, how large are ACME’s fixed costs? Its
sunk costs?
Fixed costs = $5,000
Within 2 days: Sunk costs = $5,000 - $1,000 = $4,000
After 2 days: Sunk costs = $5,000
2. One day after signing the lease, ACME realizes that it has no use for the railcar. A
farmer has a bumper crop of corn and has offered to sublease the railcar from
ACME at a price of $4,500. Should ACME accept the farmer’s offer?
If ACME returns the railcar to Reading Railroad, it will only lose $4,000 as a sunk
cost.
If ACME accept the farmer’s offer, it will only lose -$5,000 + $4,500 = -$5,000.
→ In conclusion, ACME should accept the farmer’s offer.

Exercise 2: A firm estimates its cubic production function of the form Q = AL3 + BL2 (total
product) and obtains the following estimation results:

1. What are the estimated total, average, and marginal product functions?
TC = Q = AL3 + BL3 = -0.002L3 + 0.4L2
AC = AL2 + BL = -0.002L2 + 0.4L
MP = 3AL2 + 2BL = -0.006L2 + 0.8L
2. Are the parameters of the correct sign, and are they significant at the 1% level?
Parameters are of correct sign because p-value = 0.0005 and 0.0001 are smaller than
0.01. They are all significant at the 1% level.
3. At what level of labour usage is the average product at its maximum? Assume that
the wage rate for labour (w) is $200.
APmax <=> MP = AP <=> L = 100
4. What is output when the average product is at its maximum? Q = 2000
Exercise 3: Consider estimation of a short-run average variable cost function of the form:
AVC = a + bQ + cQ2. Using time-series data, the estimation procedure produces the
following computer output:

1. Do the parameter estimates have the correct signs? Are they statistically
significant at the 5% level of significance?
The parameters are of the correct sign and are statistically significant at the 5%
level because p-value = 0.0232 and 0.0176, which is smaller than 0.05.
2. At what level of output do you estimate average variable cost reaches its minimum
value?
AVC min <=> Qm = -b/2c = 0.079952/2*0.000088 = 454.27273
3. What is the estimated marginal cost curve?
SMC = a + 2bQ + 3cQ2
= 30.420202 - 0.159904Q + 0.000264Q2
4. What is the estimated marginal cost when output is 700 units?
SMC = 30.420202 - 0.159904*700 + 0.000264*7002 = 47.847402
5. What is the estimated average variable cost curve?
AVC = a + bQ + cQ2 = 30.420202 - 0.079952Q + 0.000088Q2
6. What is the estimated average cost when output is 700 units?
AVC = 30.420202 - 0.079952*700 + 0.000088*7002 = 17.573802

3.1.2. PRODUCTION & COSTS IN THE LONG RUN

● Marginal Rate of Technical Substitution (MRTS) is the slope of an isoquant &
measures the rate at which the two inputs can be substituted for one another
while maintaining a constant level of output

A minus sign is added to make MRTS a positive number since K/L, the slope of the
isoquant is negative.

C: expenditure / budget
● The slope of an isocost curve is the negative of the input price ratio (-w/r)
● K-intercept is (C ̅)/r
● Represents the amount of capital that may be purchased if zero labour is
purchased
 ● Consider A and B, which lie on the same isoquant => capital intensive
○ A is on the higher isocost curve
○ B is on the lower isocost curve
=> A and B can produce the same unit of output but with different costs.
=> Choose B: a better option but not the optimal option
● Consider C => labour-intensive
● Consider E: a tangent between isoquant and isocost, which means that they have
the same slope
● Optimal Combination of Inputs

○ Minimize total cost (TC) of producing Q by choosing the input combination

on the isoquant for which Q is just tangent to the isocost curve
○ Two slopes are equal in equilibrium
○ Implies marginal product per dollar spent on the last unit of each input is
the same
● Long-run Total Cost: measures the cost per unit of output when production can be
adjusted so that the optimal amount of each input is employed

○ LTC = wL* + rK*

○ LAC is U-shaped
○ LMC lies below LAC when LAC is
falling => economies of scale
○ LMC lies above LAC when LAC is
rising => diseconomies of scale
○ LMC = LAC at the minimum value of
LAC

Long-Run Average & Marginal Cost

LMC intercept LAC at LAC’s minimum point
=> LACmin when LMC = LAC
=> The firm reaches the economies of scale (The
greater the quantity of output produced, the
lower the per-unit fixed cost)
=> Cost advantage
Exercise 4:
Terry’s Lawn Service rents five small push mowers and two large riding mowers to cut the
lawns of neighbourhood households. The marginal product of a small push mower is 3
lawns per day, and the marginal product of a large riding mower is 6 lawns per day. The
rental price of a small push mower is $10 per day, whereas the rental price of a large
riding mower is $25 per day. Is Terry’s Lawn Service utilizing small push mowers and large
riding mowers in a cost-minimizing manner?
Answer:
MPs = 3 (small push mower/day)
Ps = 10 (rental price)
MPL = 10 ; PL = 25
=> Not optimal
=> The firms should increase the use of small mowers and reduce the use of large mowers
since the use of small mowers is more efficient.

3.2. THE ORGANIZATION OF A FIRM

3.2.1. METHODS OF PROCURING INPUTS
Exercise 5:
The market price of the product is $100/unit. The seller offers to sell the product at the
price of $109/unit. The manager wants to purchase the product at the market price. Will
the manager accept the offer?
Answer:
It depends on different factors to decide whether to accept this kind of offer.
● The manager will accept because he will get $119.
● The manager will not accept because if the buyer wants to buy the product in
large quantity, the buyer will find other sellers that sell the product at a lower price.

3.2.2. OPTIMAL PROCUREMENT INPUT

Exercise 6:
Spot exchange
Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound hamburgers in a
given week. To meet that demand, Jiffyburger needs 2,000 pounds of ground beef
delivered to its premises every Monday morning by 8:00 AM sharp.
1. As the manager of a Jiffyburger franchise, what problems would you anticipate if you
acquired ground beef using spot exchange?
● The supplier may not be able to deliver the appropriate amount at the exact time
● The unqualified ground beef => underinvestment
● The supplier knows that Jiffyburger really needs that amount of ground beef at
that time, they may show up near the exact time and increase the price =>
bargaining costs, opportunism => While ground beef for hamburgers is a relatively
standardized product, the delivery of 2,000 tons of meat to a particular store
involves specialized investments (in the form of dedicated assets) on the part of
both Jiffyburger and the supplier. In particular, Jiffyburger would face a hold-up
problem if the supplier cant shows up at 8:00 AM and threatened not to unload the
meat unless Jiffyburger paid it "ransom"; it would be difficult to find another
supplier that could supply the desired quantity of meat on such short time.
2. As the manager of a firm that sells ground beef, what problems would you anticipate if
you were to supply meat to Jiffyburger through spot exchange?
● The supplier may not be able to deliver the appropriate amount at the exact time
● Because ground beef is a standardized product, Jiffyburger can find other sellers
to purchase the product.
 SPOT EXCHANGE CONTRACT VERTICAL
INTEGRATION

Concept Used if there are no “Optimal” contract length: Produce the input
transaction costs and trade-off between MC internally. Utilized when:
there are many buyers and MB of extending the - SIs generate
and sellers in the transaction costs (due
length of a contract.
input market to opportunism,
- MC increases as bargaining costs, or
contracts become longer underinvestment)
● Contracts of long - Product is extremely
duration are more complex
difficult to write - The economic
because it is harder environment is plagued
to specify all by uncertainty
contingencies, e.g.,
Vertical integration
oil price rise, new should be undertaken
technology, etc; the only when spot
less flexibility the firm exchange or contracts
has in choosing an have failed.
input supplier
- MB (avoided transaction
costs of opportunism
and bargaining) vary with
the length of the contract
● For simplicity, we can
draw a flat MB curve

Graph Price is determined by To define the optimal

the market price length
(intersection of the => MB = MC
The optimal length of the
supply and demand
contract is the L*
curves S=D)

Adv Easily to change to - Overcome hold-up Mitigate transaction

suppliers that offer problem and the need to costs
lower prices bargain over price each
time the input is to be
purchased
- Can specify prices of
the input before the
parties make specialized
investments
- Reduces the incentive
for either the buyer or
the seller to skimp on the
SIs required for the
exchange
Disadv Result in high - Managers must
transaction costs due replace the discipline of
to opportunism, the market with an
internal regulatory
bargaining costs, and mechanism
underinvestment - The firm must bear the
when input requires cost of setting up
substantial production facilities
specialized →firm no longer
specializes in doing
investments
what it does best

SPECIALIZED INVESTMENT AND CONTRACT LENGTH

The benefit of writing a longer contract will:

● increase when the product is complex and there is a special need for SI in an
exchange.
● decrease when the product is standardized, there is a low need for SI, and the
contract environment is more uncertain or complex => should write a shorter
contract.
Because the parties may face higher transaction costs when the contract expires, writing
a longer contract can solve this.
The optimal method for acquiring inputs depends on the nature of the transactions
costs and the specialized nature of the inputs being procured.
The optimal input procurement depends on the extent to which there is a
relationship-specific exchange

3.2.3. PRINCIPAL-AGENT PROBLEM

To overcome the principal-agent problem, principals must devise plans to align the
agents’ interests with the principals.

Exercise 7:
Google Buys Motorola Mobility to Vertically Integrate In a bold move, Google purchased
Motorola Mobility—the recently spun-off cellular arm of Motorola—for $12.5 billion. This
move marks an attempt by Google to vertically integrate into the smartphone hardware
market. Industry experts note that the purchase will allow Google to build prototypes and
advanced hardware devices that will help to point its software business partners in the
direction Google wants to go. Google is banking on the increased coordination between
its software and Motorola’s hardware and the reduction in risks associated with vertical
integration outweighing the costs.
If you were a decision-maker at Google, would you have recommended vertical
integration?
Answer: