CHAPTER 6:  Cost of negotiating a price.
THE ORGANIZATION OF THE
FIRM
Determine whether the following transactions involve spot
exchange, a contract, or vertical integration:
1. Clone 1 PC is legally obligated to purchase 300 computer
chips each year for the next three
years from AMI. 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.
2. Clone 2 PC purchased 300 computer chips from a firm that
ran an advertisement in the
back of a computer magazine.
3. Clone 3 PC manufactures its own motherboards and
computer chips for its personal
computers.
ANSWER:
1. Clone 1 PC is using a contract to purchase its computer
chips.
2. Clone 2 PC used spot exchange to acquire its chips.
3. Clone 3 PC uses vertical integration to obtain its chips and
motherboards
Methods of Procuring Inputs
 Spot exchange
o An informal relationship between a buyer and
seller in which neither party is obligated to
adhere to specific terms for exchange.
o when the buyer and seller of an input meet,
exchange, and then go their separate ways.
 Contract
o A formal relationship between a buyer and seller
that obligates the buyer and seller to exchange at
terms specified in a legal document.
o a legal document that creates an extended
relationship between a particular buyer and seller
of an input.
 Produce inputs internally (vertical integration)
o A situation where a firm produces the inputs
required to
 vertical integration
o When a firm shuns other suppliers and chooses to
produce an input internally
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.
 Investments and expenditures required to facilitate
exchange.
Types of “Hidden” Transaction Costs
Specialized investment
 an investment in a particular exchange that cannot be
recovered in another trading relationship.
 expenditure that must be made to allow two parties to
exchange but has little or no value in any alternative
use.
Relationship-specific exchange
 occurs when the parties to a transaction have made
specialized investments.
 the two parties are “tied together” because of the
specific investments made to facilitate exchange
between them
Types of Specialized Investments
Site specificity
 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
 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
 general investments made by a firm that allows it to
exchange with a particular buyer.
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.
Implications of Specialized Investments
Costly bargaining
 where transaction costs are low and the desired input is
of uniform quality and sold by many firms, the price of
the input is determined by the forces of supply and
demand.
 required to obtain the input.
 no “market price” for the input; the two parties in
the relationship-specific exchange bargain with
each other over a price at which the input will be
bought and sold.
 bargaining process generally is costly, as each side
employs negotiators to obtain a more favorable
price.
Underinvestment
 required to facilitate exchange, the level of the
specialized investment often is lower than the
optimal level.
 lower than optimal, resulting in higher transaction
costs because the input produced is of inferior
quality.
Opportunism and the “hold-up problem”
 When a specialized investment must be made to
acquire an input, the buyer or seller may
attempt to capitalize on the “sunk” nature of the
investment by engaging in opportunism.
Optimal Input Procurement
 How should a manager acquire inputs to minimize
costs?
o Depends on the extent of the relationship-
specific exchange.
 Spot Exchange
 A most straightforward way for a firm to obtain inputs for
a production process is to use spot exchange
 Characteristics of the spot exchange:
 No relationship-specific investment.
 The 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
.

 Disadvantages:
o Managers must create an internal regulatory
mechanism
Contracts o Bear the cost of setting up production facilities
 Characteristics of contracts: o No longer specialized in producing its output
 Use when inputs require a substantial specialized
investment
 Typically requires substantial up-front expenditures.
 Specifies prices of inputs prior to making specialized
investments.
o Reduces likelihood of opportunism.
o Reduces likelihood to skimp on specialized
investment.
 Requires decision on optimal contract length.
OPTIMAL CONTRACT LENGTH

Vertical Integration
 Produce inputs internally
 Use when inputs require
SPECIALIZED INVESTMENT AND CONTRACT o a substantial specialized investment.
LENGTH o generate significant transaction cost.
o complex contracting or uncertain economic
environments.
 Advantages:
o “Skips the middleman”
o Reduces opportunism
o Mitigates transaction costs

Managerial Compensation and the

Principal-Agent Problem
 The primary obstacle is the separation of ownership and
control.
CONTRACTING ENVIRONMENT AND CONTRACT o Principal-agent (P-A) problem: if the owner is
LENGTH
not present to monitor the manager, how can she
get the manager to do what is in her best interest?
o Owners have to incent managers since they are
not present to monitor.
Managers’ Compensation Mechanisms
 Manager’s economic trade-off
o Leisure.
o Labor
 Fixed salary
 o Receives wage independent of labor hours and show up, they will put forth more effort than they would
effort. otherwise since getting caught “goofing off” may lead
 No strong incentive to monitor other to dismissal or a reduction in pay.
employees labor hours and effort. Disadvantage of spot checks
 Adversely impacts firm performance.  occur frequently enough to induce workers not to risk
 Incentive contract getting caught shirking
o Tie manager wage to firm performance (like  entail some penalty for workers caught shirking.
profits).  in effect, through threat.
o Manager makes labor-leisure choice and is  Performance bonuses - work through a promise of
accordingly compensated. reward.
Incentive Contracts  These characteristics can have different psychological
 chief executive officer of a corporation receives stock effects on workers
options and other bonuses directly related to profits.
 A way to align owners’ interests with that of the actions
of its manager.
 Examples include:
o Stock option
o Other bonuses directly related to profits.
External Incentives
 Outside forces can provide manages with the incentive
to maximize profits, and include:
o Reputation
o Takeover threat

The Manager-Worker
Principal-Agent Problem
 The owner-manager, principal-agent problem is not
unique.
o A similar problem exists between the firm’s
managers and the employees he or she
supervises.
Solutions to the Manager-Worker Principal-Agent Problem
 Manager-worker principal-agent problem solutions:
 Profit sharing
 Mechanism used to
enhance workers’ efforts
that involves tying
compensation to the
underlying profitability of
the firm.
 Revenue sharing
 enhance workers’ efforts
that involves linking
compensation to the
underlying revenues of
the firm
 effective when worker productivity is related to
revenues rather than costs
 TIP AND SALES COMMISSION
 Piece rates
 pay workers based on a piece rate rather than on a
fixed hourly wage.
 effort must be expended in quality control
 Time clocks and spot checks
 assist managers in monitoring workers

 Spot checks
o allow the manager to verify not only that workers
are physically present but also that worker effort
and the quality of the work are satisfactory
Advantage of spot checks
 reduce the cost of monitoring workers.
 Managers needn’t be in several places at the same time
because workers do not know when the manager will