Managerial Economics and
Business Strategy:
Ch. 6 - The Organization of
the Firm
Rayhan Gunaningrat, SE., MM.
Department of Management
Faculty of Law and Business
Universitas Duta Bangsa
Outline
HEADLINE OPTIMAL INPUT PROCUREMENT
INTRODUCTION THE PRINCIPAL-AGENT PROBLEM
METHODS OF PROCURING INPUTS ANSWERING THE HEADLINE
TRANSACTION COSTS
headLINE:
Google Buys Motorola Mobility to Vertically Integrate
Google purchased Motorola Mobility for $12.5 billion. This
move marks an attempt by Google to vertically integrate into
the smartphone hardware market. Industry experts note that
the purchase will allow Google to build prototypes and
advanced hardware devices that will help to point its software
business partners in the direction Google wants to go. Google
is banking on the increased coordination between its software
and Motorola’s hardware and the reduction in risks associated
with vertical integration outweighing the costs.
If you were a decision maker at Google, would you have
recommended vertical integration?
INTRODUCTION
In Chapter 5 we saw how a manager can select the mix of inputs that minimizes the cost of
production. However, our analysis in that chapter left unresolved two important questions:
First, what is the optimal way to acquire this efficient mix of inputs?
Second, how can the owners of a firm ensure that workers put forth the maximum effort
consistent with their capabilities?
In this chapter, we address these two issues.
MANAGER’S ROLE
➔ Procure inputs in the least cost
manner, like point B.
➔ Provide incentives for workers to
put forth effort.
➔ Failure to accomplish this results in
a point like A.
➔ Achieving points like B managers
must:
◆ Use all inputs efficiently.
◆ Acquire inputs by the least costly
method.
METHODS OF PROCURING INPUTS
Consider the manager of a car rental company. One input needed to produce output
(rental cars) is automobile servicing (tune-ups, oil changes, lube jobs, and the like). The
manager has three options:
(1) Simply take the cars to a firm that services automobiles and pay the market price for
the services;
(2) Sign a contract with a firm that services automobiles and, when service is needed,
pay the price negotiated in the contract for that particular service; or
(3) Create within the firm a division that services automobiles.
METHODS OF PROCURING INPUTS (2)
➔ Spot Exchange “Purchase the Inputs”
◆ Often is used when inputs are “standardized.”
◆ A key advantage of acquiring inputs with spot exchange is that the firm gets to specialize
in doing what it does best.
➔ Contracts “Acquire Inputs Under a Contract”
◆ A formal relationship between a buyer and seller that obligates the buyer and seller to
exchange at terms specified in a legal document.
◆ Contracts also allow the purchasing firm a greater ability to purchase “nonstandard”
inputs for which there may not be many suppliers.
◆ Disadvantage: Costly in a complex environment.
➔ Vertical Integration “Produce the Inputs Internally”
◆ This allows the firm to utilize highly “nonstandard” inputs.
◆ Disadvantage: Lost specialization and may increase organizational costs.
TRANSACTION COSTS
SPECIALIZED INVESTMENT
TRANSACTION COSTS
➔ Costs of acquiring an input over and above the amount paid to the input
supplier.
➔ Includes:
◆ Search costs. The cost of searching for a supplier willing to sell a given input.
◆ Negotiation costs. These costs may be in terms of the opportunity cost of
time, legal fees, and so forth.
◆ Other required investments or expenditures.
➔ Some transactions are general in nature while others are specific to a
trading relationship.
Specialized Investments
➔ Investments made to allow two parties to exchange but has little or no
value outside of the exchange relationship.
➔ Types of specialized investments:
◆ Site specificity. To minimize transportation cost.
◆ Physical-asset specificity. The capital equipment needed to meet the needs
of a particular buyer and cannot be readily adapted to produce inputs needed
by other buyers.
◆ Dedicated assets. A general investments made by a firm that allow it to
exchange with a particular buyer.
◆ Human capital. In many employment relationships, workers must learn
specific skills to work for a particular firm.
Specialized Investments (2)
➔ Lead to higher transaction costs
◆ Costly bargaining. There generally is no “market price” for the input.
◆ Underinvestment. The level of the specialized investment often is lower than
the optimal level “inferior quality”.
◆ Opportunism and the “Hold-Up problem”.
● Opportunism claims human beings are generally self-interested and
will take advantage of others when possible.
● The Hold-Up Problem is a situation where two parties may be able to
work most efficiently by cooperating but refrain from doing so because
of concerns that they may give the other party increased bargaining
power and thus reduce their own profits.
Specialized Investments and Contract
Length
The “optimal” contract length reflects a
fundamental economic trade-off
between the marginal costs and
marginal benefits of extending the
length of a contract.
The longer the contract, the less
flexibility the firm has in choosing an
input supplier. For these reasons, the Optimal
Contract
marginal cost of contract length in is
Length
upward sloping.
(MB=MC)
The benefits may vary with the length of
the contract, but for simplicity we have
drawn a flat MB curve.
Specialized Investments and Contract
Length (2)
The optimal contract length will
increase when the level of specialized
investment required to facilitate an
exchange increases.
To see this, note that as specialized
investments become more important,
the parties face higher transaction costs
once the contract expires.
Specialized Investments and Contract
Length (3)
This increase in the complexity of the
contracting environment increases the
marginal cost of writing longer contracts
from MC0 to MC2.
Faced with such a prospect, a manager
may wish to use yet another method to
procure a necessary input: have the firm
integrate vertically and make the input
itself.
Specialized Investments and Contract
Length (4)
This decrease in the complexity of the
contracting environment and the future
economic environment becomes more
certain, decreases the marginal cost of
writing contracts from MC0 to MC1.
THE PRINCIPAL-AGENT
PROBLEM
OWNER-MANAGER
MANAGER-WORKER
THE PRINCIPAL-AGENT PROBLEM
➔ Occurs when the principal cannot observe the effort of the agent.
◆ Example: Owner (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.
➔ Manager’s must recognize the existence of the principal-agent problem
and devise plans to align the interests of workers with that of the firm.
➔ Owner(s) must create plans to align the interest of the manager with
those of the shareholders.
Solving the Problem Between Owner(s)
and Manager(s)
➔ Internal incentives
◆ Incentive contracts.
◆ Stock options, year-end bonuses.
➔ External incentives
◆ Personal reputation.
◆ Potential for takeover.
Solving the Problem Between Manager(s)
and Workers
➔ Profit sharing
◆ If both quantity and quality of output are concerns, profit sharing is an excellent
motivator.
➔ Revenue sharing
◆ if it is difficult, for the manager to monitor workers’ effort and there is uncertainty
regarding what final sales will be, revenue sharing is an effective motivator.
➔ Piece rates
◆ If it is desirable to produce a high level of output with very little emphasis on
quality, piece-rate pay schemes work well.
➔ Time clocks and spot checks
◆ if all a manager wants from a worker is for the worker to show up at the workplace,
an hourly wage rate and a time clock form an excellent incentive scheme.
Conclusion
➔ The optimal method for acquiring inputs depends on the
nature of the transactions costs and specialized nature of
the inputs being procured.
➔ To overcome the principal-agent problem, principals must
devise plans to align the agents’ interests with the
principals.
ANSWERING THE headLINE
Smartphone software and hardware require a great deal of interoperability to work well
together. This means that both the software producers and hardware manufacturers often must
make substantial specialized investments. Google’s purchase of Motorola Mobility gives it direct
control of the specialized hardware investments made by Motorola Mobility, ensuring they will
be tailored for Google’s software products and avoiding any risk of hold-up. The high-tech
nature of the smartphone market also makes for significant uncertainty about future products
and market conditions, resulting in a complex contracting environment. Consequently, there is
sound economic rationale for vertical integration, but before making such a recommendation
you should verify that the expected benefits of avoided hold-up problems and quality
improvements justify the costs of vertical integration.
