Organization of Firm

Learning Objectives:
• How do firms hire inputs of production?
• What are transaction costs?
• What is the Principal-Agent problem?
How can a firm hire inputs?
• Spot Exchange: Purchasing inputs as requirements arise, without any
continual obligation
• Contract: Legally binding continual exchange between the firm and the
input suppliers
• Vertical Integration: Production of inputs internally
Transaction Costs
• Transaction Costs are the excess costs incurred for acquiring inputs
other than the prices of inputs.
• Two types:
• Search cost
• Matching cost
Specialized Investment and relationship-specific
Exchange
• Specialized investments are non-transferable investments to facilitate a
relationship-specific exchange
• Types of specialized investments
• Site specificity
• Physical asset specificity
• Dedicated assets
• Human capital
Specialized Investments and Transaction Costs
• Costly Bargaining
• Underinvestment
• Opportunism
Optimal Input Procurement
• It is firm specific and depends on the features of a particular
production process, legal environment, and overall economic
situation.
• Example: ATMs and a Rising Number of Bank Tellers?
• Example: Outsourcing at Ericsson
Principal-Agent Problem
• When ownership is separated from control, how do the owners
monitor their employees, and ensure that they are putting the
maximum effort?
• How does a manager ensure that employees are not shirking?
• Solution: Devise an incentive mechanism
• Example: Jack Welch and General Electric