CHAPTER 6

The Organization of
the Firm

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Overview
Chapter Outline
• Methods of procuring inputs
– Purchase inputs using spot exchange
– Acquire inputs under a contract
– Produce inputs internally
• Transaction costs
– Types of specialized investments
– Implications of specialized investments
• Optimal input procurement
– Spot exchange
– Contracts
– Vertical integration
– Economic tradeoff
• Managerial compensation and the principal-agent problem
• Forces that discipline managers
– Incentive contracts
– External incentives
• Manager-worker principal-agent problem
– Solutions to the manager-worker principal-worker problem

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 Headline
• http://www.vanguardngr.com/2011/05/qatar-
airways-moves-into-hospitality-tour-packaging/

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 Chapter Overview
Introduction
• This chapter addresses the following two
questions:
– What is the optimal way to acquire the efficient
mix of inputs?
– How can owners of a firm ensure that workers put
forth maximum effort consistent with their
capabilities?

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 Introduction

Management’s Role
Producing at Minimum Cost
Costs Minimum
($) cost function

$100 A

B
$80

0 10 Output

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How to produce on the cost function (Point
B)?
• Methods of Procuring Inputs
– Spot exchange
– Contracts
– Vertical integration

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 Methods of Procuring Inputs

Methods of Procuring Inputs

• Spot exchange
– An informal relationship between a buyer and
seller in which neither party is obligated to adhere
to specific exchange.
– Buyers and sellers are anonymous.
– No formal (legal) relationship between buyers and
sellers.
– Advantage: The firm gets to specialize in doing
what it does best; converting inputs into output;
and the input manufacturer specializes in what it
does best; producing inputs.
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 Methods of Procuring Inputs

Methods of Procuring Inputs (cont)

• Contract
– A formal relationship between a buyer and seller that
obligates the buyer and seller to exchange at terms
specified in a legal document.
– They agree to exchange over a given time horizon e.g.
3 years.
– Advantage: allow the purchasing firm to specialize in
what it does best & able to purchase ‘nonstandard’
inputs.
– Disadvantage: contracts are costly to write, it takes
time, involve legal fees and difficult to cover all
contingencies.
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 Methods of Procuring Inputs

Methods of Procuring Inputs (cont)

• Produce inputs internally (vertical integration)
– A situation where a firm produces the inputs
required to make its final product.
– Or when a firm shuns other suppliers and chooses
to produce input internally.
– Leads to bureaucratic costs.
– Example: Ford, Air Asia

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 Methods of Procuring Inputs

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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DISCUSSION

1. OTHER TYPES OF PROCUREMENT?

2. HOW TO IMPROVE GOVERNMENTS’

PROCUREMENT PROCESS?

12
 Transaction Costs
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 – opportunity cost of
time, legal fees etc.
– Other investments and expenditures required to
facilitate exchange.
– Example: Cost per unit RM10 but you need to
provide own transport and driver to pick up the
inputs which involved extra costs.
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 Transaction Costs
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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 Transaction Costs

Types of Specialized Investments

• Types of specialized investments
– Site specificity: occurs when the buyer and seller of
an input must locate their plants close to each other
to be able to engage in exchange.
– Physical-asset specificity: the capital equipment
needed to produce an input is designed to meet the
needs of a particular buyer.
– Dedicated assets: general investments made by a
firm that allow it to exchange with a particular buyer.
– Human capital: specific skills to work for a particular
firm.

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 Transaction Costs

Implications of Specialized Investments

• Specialized investments increase transaction
cost.
• Implications of specialized investments
– Costly bargaining
• http://www.youtube.com/watch?v=q4LjxhEoRp8
– Underinvestment: lower than the optimal level.
– Opportunism and the “hold-up problem”

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 Managerial Compensation and the Principal Agent Problem
Compensation and the
Principal-Agent Problem
• Having learned about the principal factors in selecting
the best methods of acquiring inputs, we now explain
how to compensate labor inputs to put forth maximal
effort.
• The primary obstacle is the separation of ownership
and control.
– Principal-agent (P-A) problem leads to the following
question: Is poor performance due to
• bad luck?
• low manager effort?
– Owners have to incent managers since they are not present
to monitor.
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 Managerial Compensation and the Principal Agent Problem

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 wage to firm performance (like profits).
– Manager makes labor-leisure choice and is accordingly
compensated.
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 Forces that Discipline Managers

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

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 Forces that Discipline Managers

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 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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 The Manager-Worker Principal-Agent Problem

Solutions to the Manager-Worker 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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 Exercise
• Select one issue relating to manager-worker
principal-agent problem and suggest strategies
to overcome the problem.
• 1 page – typewritten – single spacing – TNR 12

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