Chapter 6

The Organization of the Firm

Management’s Role – Producing at Minimum Cost
(Figure 6-1)

Costs Minimum
($) cost function

$100 A

B
$80

0 10 Output

A manager’s role is to minimize the cost of production.

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 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 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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 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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 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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 Types of Specialized Investments

• Site specificity

• Physical-asset specificity

• Dedicated assets

• Human capital

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 Implications of Specialized Investments

• Costly bargaining

• Underinvestment

• Opportunism and the “hold-up problem”

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 Optimal Input Procurement

How should a manager acquire inputs to minimize costs?

• Depends on the extent to which there is relationship-specific

exchange.

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 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 on the part of sellers can add extra time to bargaining over price and
incur additional costs if negotiations break down.
• Underinvestment in specialized investments can lead to inferior quality of the
input

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 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 Contract Length (Figure 6-2)
MB, MC MC
($)

MB

0 𝐿∗ Contract Length
(in years)

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Specialized Investments and Contract Length (Figure 6-3)
MB, MC
($) MC

MB1
Greater need for
specialized investment
MB0

0 𝐿0 𝐿1 Contract Length

Longer contract

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Contracting Environment and Contract Length (Figure 6-4)
MB, MC MC2 MC0 MC1
($)
More complex
contracting Less complex
environment contracting
environment

MB

0 L2 𝐿0 𝐿1 Contract Length

Shorter contract Longer contract

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 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 Procurement of Inputs (Figure 6-5)

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 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 must incent managers since they are not present to monitor.

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 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’s wage is tied to firm performance (like profits).
• Manager makes labor-leisure choice and is accordingly compensated.

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 Incentive Contracts
A way to align owners’ interests with that of the actions of its manager.
Examples include:
• Stock options
• Other bonuses directly related to profits.

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 External Incentives
Outside forces can provide manages with the incentive to maximize
profits, and include:
• Reputation
• Takeover threat

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 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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 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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 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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