Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
Business Strategy
Chapter 6
The Organization of the Firm
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Overview
I,Methods of Procuring Inputs
? Spot Exchange
? Contracts
? Vertical Integration
II,Transaction Costs
? Specialized Investments
III,Optimal Procurement Input
IV,Principal-Agent Problem
? Owners-Managers
? Managers-Workers
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Manager’s Role
? Procure inputs in the
least cost manner
? Provide incentives for
workers to put forth
effort
? Failure to accomplish
this results in a point
like A
$100
80
$10 0
Output
Costs
A
B
C(Q)
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Methods of Procuring Inputs
? Spot Exchange
? When the buyer and seller of an input meet,exchange,
and then go their separate ways,
? Contracts
? A legal document that creates an extended relationship
between a buyer and a seller,
? Vertical Integration
? When a firm shuns other suppliers and chooses to
produce an input internally,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Key Features
? Spot Exchange
? Specialization,avoids contracting costs,avoids costs of
vertical integration,
? Possible,hold-up problem”
? Contracting
? Specialization,reduces opportunism,avoids skimping
on specialized investments
? Costly in complex environments
? Vertical Integration
? Reduces opportunism,avoids contracting costs
? Lost specialization,organizational costs
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Transaction Costs
? Costs of acquiring an input over and above
the amount paid to the input supplier,
? Includes,
? Search costs
? Negotiation costs
? Other required investments or expenditures
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Specialized Investments
? Investments made to allow two parties to
exchange but has little or no value outside of the
exchange relationship
? Site specificity
? Physical-asset specificity
? Dedicated assets
? Human capital
? Lead to higher transaction costs and the problem
of,hold-up”
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Specialized Investments
and Contract Length
MB0
MC
L0
$
Contract
Length 0 L1
MB1
Longer Contract
Due to greater need for
specialized investments
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Input Procurement
Substantial
specialized
investments
relative to
contracting costs?
Spot Exchange No
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Yes
Contract
No
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Principal-Agent Problem
? Occurs when the principal cannot observe the
effort of the agent
? Example,Shareholders (principal) cannot observe the effort
of the manager (agent)
? Example,Manager (principal) cannot observe the effort of
workers (agents)
? The Problem,Principal cannot determine
whether a bad outcome was the result of the
agent’s low effort or due to bad luck
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Solving the Problem Between
Owners and Managers
? Internal incentives
? Incentive contracts
? Stock options,year-end bonuses
? External incentives
? Personal reputation
? Potential for takeover
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Solving the Problem Between
Managers and Workers
? Profit sharing
? Revenue sharing
? Piece rates
? Time clocks and spot checks