lecture5

6-11
6-12
2
27/10/2014
Contracts
Optimal Input Procurement
• Characteristics of contracts:
– Use when inputs require a substantial specialized investment.
– Typically requires substantial up-front expenditures.
MB1 MB0 Contract Length
6-15
MB, MC ($)
Optimal Input Procurement
Specialized Investments and
Contract Length In Action
MC1
MC0
MC2
More complex contracting environment
– Cost of searching for a supplier. – Cost of negotiating a price. – Investments and expenditures required to
facilitate exchange.
Transaction Costs
Types of “Hidden” Transaction Costs
• Types of specialized investments
– Site specificity. – Physical-asset specificity. – Dedicated assets. – Human capital.
Transaction Costs
Implications of Specialized Investments
• Transaction costs – Types of specialized investments – Implications of specialized investments
• Optimal input procurement – Spot exchange – Contracts – Vertical integration – Economic tradeoff
– A type of exchange that occurs when the parties to a transaction have made specialized investments.
6-7
6-8
Transaction Costs
Types of Specialized Investments
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 $200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years. – Clone 2 PC purchased 300 computer chips from a firm that ran an advertisement in the back of a computer magazine. – Clone 3 PC manufactures its own motherboards and computer chips for its personal computers.
– a substantial specialized investment. – generate significant transaction cost. – complex contracting or uncertain economic environments. • Advantages: – “Skips the middleman.” – Reduces opportunism. – Mitigates transaction costs. • Disadvantages: – Managers must create an internal regulatory mechanism. – Bear the cost of setting up production facilities. – No longer specialized in producing its output.
– Requires decision on optimal contract length.
6-13
Optimal Input Procurement
Optimal Contract Length In Action
MB, MC
MC
($)
MB
0
‫∗ܮ‬
Contract Length
(in years)
Less complex contracting environment
MB
0
‫ܮ‬ଵ
‫ܮ‬଴
‫ܮ‬ଶ C Longer contract
6-16
Optimal Input Procurement
Vertical Integration
• Produce inputs internally. • Use when inputs require
• 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
– 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?
Optimal Input Procurement
• How should a manager acquire inputs to minimize costs?
– Depends on the extent of the relationship-specific exchange.
Optimal Input Procurement
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
• Answers: – Clone 1 PC is using a contract. – Clone 2 PC used the spot exchange. – Clone 3 PC uses vertical integration.
6-6
1
27/10/2014
Transaction Costs
6-14
MB, MC ($)
Optimal Input Procurement
Specialized Investments and Contract Length In Action
MC
Greater need for specialized investment
0
‫ܮ‬଴
‫ܮ‬ଵ
Longer contract
• Implications of specialized investments
– Costly bargaining. – Underinvestment . – Opportunism and the “hold-up problem.”
6-9
6-10
Optimal Input Procurement
Spot Exchange
• Characteristics of the spot exchange:
– No relationship-specific investment. – Absence of transaction costs, and many buyers
and sellers, imply that the market price is determined by the intersection of demand and supply. – Opportunism. – Underinvestment in specialized investments.
6-3
Management’s Role
Costs ($)
Producing at Minimum Cost
$100
A
B $80
Introduction
Minimum cost function
0
10
Output
6-4
Methods of Procuring Inputs
Methods of Procuring Inputs
• Produce inputs internally (vertical integration)
– A situation where a firm produces the inputs required to make its final product.
6-5
Methods of Procuring Inputs
27/10/2014
MANAGERIAL ECONOMICS LECTURE 5
The Organization of the Firm
Lecture Outline
Lecture Overview
• Methods of procuring inputs – Purchase inputs using spot exchange – Acquire inputs under a contract – Produce inputs internally
• 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
– Specifies prices of inputs prior to making specialized investments.
• Reduces likelihood of opportunism. • Reduces likelihood to skimp on specialized investment.
• Spot market
– An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific 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.
6-2
Introduction
Lecture Overview
• Lecture 4 focused on how to select the mix of inputs that minimizes the cost of production.
• This lecture addresses the following two questions: