The Organization of the Firm

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METHODS OF PROCURING INPUTS

A manager can use several approaches to obtain the inputs needed to produce a final
product
three methods of acquiring inputs:
1. Purchase the Inputs Using Spot Exchange

Spot Exchange - An informal relationship between a buyer and seller in which

neither party is obligated to adhere to specific terms for exchange.
Spot exchange occurs when the buyer and seller of an input meet, exchange,
and then go their separate ways.
2. Acquire Inputs under a Contract

Contract - A formal relationship between a buyer and seller that obligates the
buyer and seller to exchange at terms specified in a legal document.
A contract is a legal document that creates an extended relationship between a
particular buyer and seller of an input.
3. Produce the Inputs Internally

Vertical Integration - A situation where a firm produces the inputs required to

make its final product.

TRANSACTION COSTS
Transaction Costs - Costs associated with acquiring an input that are in excess of the
amount paid to the input supplier.
The transaction costs of acquiring an input are the costs of locating a seller of the
input, negotiating a price at which the input will be purchased, and putting the input to
use. Transaction costs include:
1. The cost of searching for a supplier willing to sell a given input.
2. The costs of negotiating a price at which the input will be purchased. These costs
may be in terms of the opportunity cost of time, legal fees, and so forth.
3. Other investments and expenditures required to facilitate exchange.

Specialized Investment - An expenditure that must be made to allow two parties to

exchange but has little or no value in any alternative use.
A specialized investment is simply an investment in a particular exchange that cannot
be recovered in another trading relationship.
 Relationship-Specific Exchange - A type of exchange that occurs when the parties to a
transaction have made specialized investments.
The distinguishing feature of relationship-specific exchange is that the two parties are
“tied together” because of the specific investments made to facilitate exchange
between them.
Types of Specialized Investments
Site Specificity - occurs when the buyer and the seller of an input must locate their plants
close to each other to be able to engage in exchange.
Physical-Asset Specificity - refers to a situation where the capital equipment needed to
produce an input is designed to meet the needs of a particular buyer and cannot be readily
adapted to produce inputs needed by other buyers.
Dedicated Assets - are 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. If these skills are not useful or transferable to other employers,
they represent a specialized investment.
Implications of Specialized Investments
Costly Bargaining - transaction costs are low and the desired input is of uniform quality
and sold by many firms, the price of the input is determined by the forces of supply and
demand
Underinvestment - When specialized investments are required to facilitate exchange, the
level of the specialized investment often is lower than the optimal level.
Opportunism and the “Hold-Up Problem” - When a specialized investment must be
made to acquire an input, the buyer or seller may attempt to capitalize on the “sunk” nature
of the investment by engaging in opportunism

OPTIMAL INPUT PROCUREMENT

Spot Exchange
The most straightforward way for a firm to obtain inputs for a production process is to
use spot exchange
If there are no transaction costs and there are many buyers and sellers in the input
market, the market price (say, p*) is determined by the intersection of the supply and
demand curves for the input.
The manager can easily obtain the input from a supplier chosen at random by paying
a price of p* per unit of input. If any supplier attempted to charge a price greater than
p*, the manager could simply decline and purchase the input from another supplier at
a price of p*.
spot exchange does not insulate a buyer from opportunism, and the parties may end
up spending considerable time bargaining over the price and incur substantial costs if
 negotiations break down
Contracts
Given the prospect of the hold-up problem and a need to bargain over price each time
an input is to be purchased, an alternative strategy is to acquire an input from a
particular supplier under an appropriately structured contract.
First, a contract can specify prices of the input before the parties make specialized
investments.
Second, by guaranteeing an acceptable price for both parties for an extended time
horizon, a contract reduces the incentive for either the buyer or the seller to skimp on
the specialized investments required for the exchange
Vertical Integration
When specialized investments generate transaction costs (due to opportunism,
bargaining costs, or underinvestment), and when the product being purchased is
extremely complex or the economic environment is plagued by uncertainty, complete
contracts will be extremely costly or even impossible to write. The only choice left is for
the firm to set up a facility to produce the input internally. This process is referred to as
vertical integration because it entails the firm moving farther up the production stream
toward increasingly basic inputs.
The Economic Trade-Off
The cost-minimizing method of acquiring an input depends on the characteristics of
the input. Whether a manager chooses spot exchange or an alternative method such
as a contract or vertical integration depends on the importance of the specialized
investments that lead to relationship-specific exchange

MANAGERIAL COMPENSATION AND THE PRINCIPAL–AGENT

PROBLEM
One characteristic of many large firms is the Separation of Ownership and Control: The
owners of the firm often are distantly located stockholders, and the firm is run on a day-to-
day basis by a manager. The fact that the firm’s owners are not physically present to
monitor the manager creates a fundamental incentive problem.
By creating a firm, an owner enjoys the benefits of reduced transaction costs. But when
ownership is separated from control, the principal–agent problem emerge

FORCES THAT DISCIPLINE MANAGERS

Incentive Contracts
External Incentives
Reputation
 Managers have increased job mobility when they can demonstrate to other firms
that they have the managerial skills needed to maximize profits.
Takeovers
Another external force that provides managers with an incentive to maximize
profits is the threat of a takeover

THE MANAGER–WORKER PRINCIPAL–AGENT PROBLEM

Solutions to the Manager–Worker Principal–Agent Problem
Profit Sharing - Mechanism used to enhance workers’ efforts that involves tying
compensation to the underlying profitability of the firm.
Revenue Sharing - Mechanism used to enhance workers’ efforts that involves linking
compensation to the underlying revenues of the firm.
Piece Rates - to pay workers based on a piece rate rather than on a fixed hourly
wage.
Time Clocks and Spot Checks - Time clocks essentially are designed to verify when
an employee arrives and departs from the job. Spot checks allow the manager to
verify not only that workers are physically present but also that worker effort and the
quality of the work are satisfactory.