CHAPTER 5

ECONOMICS OF
ORGANIZATION
5.1 REASONS TO EXPAND
AN ENTERPRISE
usually sell multiple products or services,
and they alter the collection of goods and
services provided over time.
Several factors motivate changes in this
composition and can result in decisions either to
expand an enterprise by increasing the range of
goods and services offered or to contract the
enterprise by suspending production and sale of
some goods and services.
 IN THIS SECTION, WE WILL LIST SOME

KEY MOTIVATIONS FOR

EXPANDING THE RANGE
OF AN ENTERPRISE
KEY MOTIVATIONS FOR EXPANDING
THE RANGE OF AN ENTERPRISE
1. Cost and Production

• economies of scale (cost per unit decreases as volume increases)

• economies of scope (costs per unit of different goods can be
reduced by producing multiple products using the same
production resources)
KEY MOTIVATIONS FOR EXPANDING
THE RANGE OF AN ENTERPRISE
2. Firm Competition and Market Structure

• in markets with few sellers that each provide a large fraction of

the goods or services available, the sellers possess an advantage
over buyers in commanding higher prices.
KEY MOTIVATIONS FOR EXPANDING
THE RANGE OF AN ENTERPRISE

• businesses will often either buy out competitors or increase

production with the intent to drive competitors out of the seller
market in order to gain market power.
• Many businesses sell products that are intermediate, rather
than final, goods.

• Their customers are other businesses that take the goods

or services they purchase and combine or enhance them to
provide other goods and services.
• As a result, the profit that is earned in the production of a
final product will be distributed across several firms that
contributed to the creation of that good. However, the
profit may not be evenly distributed across the
contributing firms or proportional to their costs.
• Sometimes a firm will recognize the higher profit
potential of the firms that supply them or the firms to
which they are suppliers and will decide to participate in
those more lucrative production stages.
 5.2 CLASSIFYING
BUSINESS EXPANSION IN
TERMS OF VALUE CHAINS
VALUE CHAIN FOR THE PRODUCT
• network of operations that account for the creation of a
product

GENERIC VALUE CHAIN FOR A

MANUFACTURED PRODUCT
• shows a generic value chain for a manufactured good
GENERIC VALUE CHAIN FOR A
MANUFACTURED PRODUCT
Extraction of Raw Materials

Processing of Raw Materials

Creation of Parts
Assembly of Parts into a Manufactured Unit

Distribution of Manufactured Unit

Retail Sale of Manufactured Unit

5.3 HORIZONTAL
INTEGRATION
HORIZONTAL INTEGRATION
• It is a competitive strategy where business entities operating at
the value chain level and within the same industry merge to
increase the production of goods and services

• In horizontal integration, a firm either increases the volume of

current production activities or expands to similar kind of
production activities.
HORIZONTAL INTEGRATION
• It happens when one firm acquires another firm operating in the
same industry or producing the same line of products.

• Acquisition, merger and internal acquisition are primary forms

of horizontal integration.
 5.4 VERTICAL
INTEGRATION
WHAT IS VERTICAL
INTEGRATION?
VERTICAL INTEGRATION
• A strategy of a business to own certain stages
of production process rather than being
dependent on suppliers or contractors
WHAT IS VALUE CHAIN?
VALUE CHAIN
• String of collaborating workers, who work
together to satisfy market demands for specific
products or services
5.5 ALTERNATIVES
TO VERTICAL
INTEGRATION
If the reduction of risk related to the actions of an
independent supplier or buyer is a motivation for
Vertical Integration, the firm may have alternatives
to formally integrating into another stage of value
chain through use of a carefully constructed
agreement with a supplier or buyer.
LONG TERM AGREEMENT
• If the concern is about reliability of continued
exchanges
 THERE ARE

2 DIFFERENT STAGES
WITHIN SUPPLY CHAIN
2 DIFFERENT STAGES WITHIN SUPPLY
CHAIN

1. UPSTREAM
2. DOWNSTREAM
UPSTREAM
• Those in which materials flow into the
organization.

• Activities in the supply chain that relate to an

organizations suppliers.
DOWNSTREAM
• Those which material flow away from the
organization to customer.

• Refers to the activities that has to do with the

distributing and getting the product to the final
consumer or customer.
If the Upstream firm is concerned that the
Downstream firm will charge too little and hurt
their profitability, they can insist “Resale Price
Maintenance”
RESALE PRICE MAINTENANCE
• Practice whereby a manufacturer and its
distributors agree that the distributors will sell
the manufacturers product at a certain prices at
or above a price floor.
If the Downstream firm is concerned that the
upstream firm will use their exchanges to build up a
business and then seek additional business with
other downstream clients at a lower price, the
downstream firms can ask for a best price policy
that guarantees them at a lower price.
When Upstream firms are concerned That they may
not realize a sufficient volume of exchanges over
time to justify the investment fixed asset, the
Upstream firm can demand a “Take-or-Pay
Contract”
TAKE-OR-PAY CONTRACT
• Obligates the buyer to either fulfill its intended purchases
or compensate the supplier to offset losses that will occur.

• The supplier would have no viable alternative for

redeveloping the fixed assets to another use
5.6 CONGLOMERATES
 WHAT IS
CONGLOMERATE?
CONGLOMERATE
• The acquisition of or merger with firms different
industries
 WHAT IS
DIVERSIFICATION?
DIVERSIFICATION
• Used to expand operations by adding markets,
products, services, or stages of production to the
existing business
5.7 TRANSACTION COSTS
AND BOUNDARIES OF THE
FIRM
TRANSACTION COST
• transaction cost is the cost involved in making an exchange

BOUNDARIES OF THE FIRM

• the responsibilities of a firm while performing its duties
EXTERNAL EXCHANGE
• when two separate businesses are involved wherein one
party is buying a product or service while the other party is
selling it

INTERNAL EXCHANGE
• exchange of assets between departments or locations, or
the payment of employees
• One consequence of a corporation growing
large and complex is that it needs a
management structure that is large and
complex. There needs to be some specialization
among managers, much as there is
specialization in its labor force.
• Another problem with expansion, especially in
the cases of vertical integration and
conglomerates, is that different kinds of
businesses may do better with different styles
of management
TRANSACTION COST ECONOMICS
• to explain when a firm should expand and when
it should not, or even when the firm would do
better to either break apart or sell off some of its
business units
COASE HYPOTHESIS
• principle states that firms should continue to
expand as long as internal transaction costs are
less than external transaction costs for the same
kind of exchange
 5.8 COST CENTERS
VERSUS PROFIT CENTERS
COST CENTER

• Large vertically integrated companies often have

at least one upstream division that creates a
product and a downstream division that
distributes it or sells it to consumers.
COST CENTER

• One design for such companies is to have a

central upper management that decides what
activities and activity levels should be provided
by each division. These instructions are given to
the division managers.
COST CENTER

• Each division will best contribute to the overall

profitability of the corporation by trying to meet
its output goals at minimum cost. As such,
divisions operating under this philosophy are
called COST CENTER.
COST CENTER

• There is some risk in the division having an

overall objective of minimizing cost and
divisional management evaluated in terms of
that objective.
COST CENTER
• The response to this objective is that the firm
may cut corners on quality as much as possible
and avoid considering innovations that would
incur higher initial costs but ultimately result in
a better product for the long run.
PROFIT CENTER

• An alternative to the cost center approach is to treat a

division as if it were like a business that had its own
revenues and costs.

• The goal of each division is to create the most value in

terms of the difference between its revenues and costs.
PROFIT CENTER

• This is known as a PROFIT CENTER.

• Division managers of profit centers not only have

incentives to avoid waste and improve efficiencies like cost
centers but also have an incentive to improve the product
in ways that create better value.
5.9 TRANSFER PRICING
WHAT IS A TRANSFER
PRICE?
TRANSFER PRICE

• it is the value assigned to the exchanged item

 WHY IS THERE A
TRANSFER OF PRICE?
WHY IS THERE A TRANSFER OF PRICE?

• for the two divisions to negotiate a price as if

they are independent business
 INTERNAL AND
EXTERNAL SITUATIONS
DIVISION A PRODUCES UNIQUE ITEM
FOR DIVISION B (INTERNAL)
• when a good is exclusively produced by
Division A and only used by Division B
 WHAT WOULD BE THE
BEST TRANSFER PRICE?
WHAT WOULD BE THE BEST
TRANSFER PRICE?
• the best transfer price would be Division A’s
marginal cost for the good
WHAT WOULD HAPPEN IF THE
TRANSFER PRICE IS “LOWER”
OR “HIGHER” THAN THE
MARGINAL COST?
WHAT WOULD HAPPEN?
If the transfer price is lower:
• Division A might reduce the supply that will be given to
Division B

If the transfer price is higher:

• it will distort Division B’s production decisions
COMPETITIVE MARKET (EXTERNAL)

• if the good is both produced and consumed

outside the enterprise (and there’s a competitive
market for it)
 WHAT WOULD BE THE
BEST TRANSFER PRICE?
WHAT WOULD BE THE BEST
TRANSFER PRICE?
• the best transfer price would be the external
market price
 WHAT WOULD BE THE
BENEFIT IF THE TRANSFER
PRICE IS “HIGHER” OR
“LOWER” THAN THE
EXTERNAL MARKET PRICE?
WHAT WOULD BE THE BENEFIT?
If the transfer price is higher:
• Division B can save cost by buying from external market

If the transfer price is lower:

• Division A would make more profit by selling externally
5.10 EMPLOYEE
MOTIVATION
TWO DIFFERENT TYPES OF
EMPLOYEE MOTIVATION
PERSPECTIVES
TRADITIONAL PERSPECTIVE
• supervision, discipline, feedback

NEW PERSPECTIVE
• treats employees as individual contractors
• they are motivated by compensation and incentives
 KEY PRINCIPLES OF
MOTIVATING EMPLOYEES
EFFICIENCY WAGES PRINCIPLE
• paying employees slightly more than their work

• encourages them to work harder

• reduces the need to find and train replacements

INFORMATIVENESS PRINCIPLE
• employee contracts should measure and reward individual
effort

• employees should be recognized and encouraged for their

hard work

• they must not worry about others dragging down their

rewards (applies to team collaboration)
CONCEPT OF SIGNALING
• employers often struggle to predict how well a new hire
will perform
• employees can show they are dedicated and competent
(through obtaining a college degree)
• this concept helps employers identify good workers and
motivates employees to maintain a strong reputation for
future job opportunities
 5.11 MANAGER
MOTIVATION AND
EXECUTIVE PAY
ARGUMENTS FOR EXECUTIVE PAY
1. Based on economic rent
2. The value they create on behalf of the owners
3. Firms must often take significant risks to
succeed in competitive markets and uncertain
conditions.
4. Tournament theory
THANK YOU!