The Organization Of The Firm
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CHAPTER 6 The Organization of the Firm
© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1. Discuss the economic trade-offs associated with obtaining inputs through spot exchange, contract, or vertical integration. 2. Identify four types of specialized investments, and explain how each can lead to costly bargaining, underinvestment, and/or a “hold-up problem.” 3. Explain the optimal manner of procuring different types of inputs. 4. Describe the principle-agent problem as it relates to owners and managers. 5. Discuss three forces that owners can use to discipline managers. 6. Describe the principal-agent problem as it relates to managers and workers. 7. Discuss four tools the manager can use to mitigate incentive problems in the workplace. © 2017 by McGraw-Hill Education. All Rights Reserved.
2
Introduction
Management’s Role Producing at Minimum Cost
Costs ($)
Minimum cost function
A
$100
B
$80
0
10
© 2017 by McGraw-Hill Education. All Rights Reserved.
Output
6-3
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 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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-4
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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-5
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. – Investments and expenditures required to facilitate exchange.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-6
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-7
Transaction Costs
Types of Specialized Investments • Types of specialized investments – Site specificity – Physical-asset specificity – Dedicated assets – Human capital
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-8
Transaction Costs
Implications of Specialized Investments • Implications of specialized investments – Costly bargaining – Underinvestment – Opportunism and the “hold-up problem”
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-9
Optimal Input Procurement
Optimal Input Procurement • How should a manager acquire inputs to minimize costs?
– Depends on the extent of the relationship-specific exchange.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-10
Optimal Input Procurement
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 – Underinvestment in specialized investments
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-11
Contracts
Optimal Input Procurement
• 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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-12
Optimal Input Procurement
Optimal Contract Length MB, MC ($)
MC
MB
0
𝐿∗
© 2017 by McGraw-Hill Education. All Rights Reserved.
Contract Length (in years)
6-13
Optimal Input Procurement
Specialized Investments and Contract Length MB, MC MC
($)
MB1 Greater need for specialized investment MB0
0
𝐿0
𝐿1
Contract Length
Longer contract © 2017 by McGraw-Hill Education. All Rights Reserved.
6-14
Optimal Input Procurement
Contracting Environment and Contract LengthMC MC MC 1
MB, MC ($)
0
2
More complex contracting environment
Less complex contracting environment MB
0
𝐿1 Shorter contract
𝐿0
𝐿2
Contract Length
Longer contract
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-15
Optimal Input Procurement
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 © 2017 by McGraw-Hill Education. All Rights Reserved.
6-16
Optimal Input Procurement
Optimal Procurement of Inputs
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-17
Managerial Compensation and the Principal Agent Problem
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 have to incent managers since they are not present to monitor.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-18
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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-19
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-20
Forces that Discipline Managers
External Incentives
• Outside forces can provide manages with the incentive to maximize profits, and include: – Reputation – Takeover threat
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-21
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-22
The Manager-Worker Principal-Agent Problem
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
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-23
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-24
© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1. Discuss the economic trade-offs associated with obtaining inputs through spot exchange, contract, or vertical integration. 2. Identify four types of specialized investments, and explain how each can lead to costly bargaining, underinvestment, and/or a “hold-up problem.” 3. Explain the optimal manner of procuring different types of inputs. 4. Describe the principle-agent problem as it relates to owners and managers. 5. Discuss three forces that owners can use to discipline managers. 6. Describe the principal-agent problem as it relates to managers and workers. 7. Discuss four tools the manager can use to mitigate incentive problems in the workplace. © 2017 by McGraw-Hill Education. All Rights Reserved.
2
Introduction
Management’s Role Producing at Minimum Cost
Costs ($)
Minimum cost function
A
$100
B
$80
0
10
© 2017 by McGraw-Hill Education. All Rights Reserved.
Output
6-3
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 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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-4
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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-5
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. – Investments and expenditures required to facilitate exchange.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-6
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-7
Transaction Costs
Types of Specialized Investments • Types of specialized investments – Site specificity – Physical-asset specificity – Dedicated assets – Human capital
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-8
Transaction Costs
Implications of Specialized Investments • Implications of specialized investments – Costly bargaining – Underinvestment – Opportunism and the “hold-up problem”
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-9
Optimal Input Procurement
Optimal Input Procurement • How should a manager acquire inputs to minimize costs?
– Depends on the extent of the relationship-specific exchange.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-10
Optimal Input Procurement
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 – Underinvestment in specialized investments
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-11
Contracts
Optimal Input Procurement
• 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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-12
Optimal Input Procurement
Optimal Contract Length MB, MC ($)
MC
MB
0
𝐿∗
© 2017 by McGraw-Hill Education. All Rights Reserved.
Contract Length (in years)
6-13
Optimal Input Procurement
Specialized Investments and Contract Length MB, MC MC
($)
MB1 Greater need for specialized investment MB0
0
𝐿0
𝐿1
Contract Length
Longer contract © 2017 by McGraw-Hill Education. All Rights Reserved.
6-14
Optimal Input Procurement
Contracting Environment and Contract LengthMC MC MC 1
MB, MC ($)
0
2
More complex contracting environment
Less complex contracting environment MB
0
𝐿1 Shorter contract
𝐿0
𝐿2
Contract Length
Longer contract
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-15
Optimal Input Procurement
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 © 2017 by McGraw-Hill Education. All Rights Reserved.
6-16
Optimal Input Procurement
Optimal Procurement of Inputs
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-17
Managerial Compensation and the Principal Agent Problem
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 have to incent managers since they are not present to monitor.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-18
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. © 2017 by McGraw-Hill Education. All Rights Reserved.
6-19
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-20
Forces that Discipline Managers
External Incentives
• Outside forces can provide manages with the incentive to maximize profits, and include: – Reputation – Takeover threat
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-21
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-22
The Manager-Worker Principal-Agent Problem
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
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-23
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.
© 2017 by McGraw-Hill Education. All Rights Reserved.
6-24
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