Slide 1Chapter OutlineIntroductionManagement’s RoleMethods of Procuring InputsMethods of Procuring Inputs In ActionTransaction CostsTypes of “Hidden” Transaction CostsTypes of Specialized InvestmentsImplications of Specialized InvestmentsOptimal Input ProcurementSpot ExchangeContractsOptimal Contract Length In ActionSpecialized Investments and Contract Length In ActionSpecialized Investments and Contract Length In ActionVertical IntegrationThe Economic Trade-OffCompensation and the Principal-Agent ProblemManagers’ Compensation MechanismsIncentive ContractsExternal IncentivesThe Manager-Worker Principal-Agent ProblemSolutions to the Manager-Worker ProblemConclusionCHAPTER 6The Organization of the Firm© 2014 by McGraw-Hill Education. All Rights Reserved.Chapter Outline•Methods of procuring inputs–Purchase inputs using spot exchange–Acquire inputs under a contract–Produce inputs internally•Transaction costs–Types of specialized investments–Implications of specialized investments•Optimal input procurement–Spot exchange–Contracts–Vertical integration–Economic tradeof•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 problemCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-2Chapter OverviewIntroduction•Chapter 5 focused on how to select the mix of inputs that minimizes the cost of production.•This chapter addresses the following two questions:–What is the optimal way to acquire the efficient mix of inputs?–How can owners of a firm ensure that workers put forth maximum efort consistent with their capabilities?Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-3Chapter OverviewManagement’s RoleCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-4Output0Costs($)Minimumcost function10$80$100ABIntroductionProducing at Minimum CostMethods of Procuring Inputs•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.•Produce inputs internally (vertical integration)–A situation where a firm produces the inputs required to make its final product.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-5Methods of Procuring InputsMethods 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.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-6Methods of Procuring InputsTransaction 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.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-7Transaction CostsTypes 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.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-8Transaction CostsTypes of Specialized Investments•Types of specialized investments–Site specificity.–Physical-asset specificity.–Dedicated assets.–Human capital.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-9Transaction CostsImplications of Specialized Investments•Implications of specialized investments–Costly bargaining.–Underinvestment .–Opportunism and the “hold-up problem.”Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-10Transaction CostsOptimal Input Procurement•How should a manager acquire inputs to minimize costs?–Depends on the extent of the relationship-specific exchange.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-11Optimal Input ProcurementSpot 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.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-12Optimal Input ProcurementContracts•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.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-13Optimal Input ProcurementOptimal Contract Length In ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-14Contract Length(in years)0�∗ MB, MC ($)MCMBOptimal Input ProcurementSpecialized Investments and Contract Length In ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-15Contract Length0�0 �1 MB, MC ($)MCMB0MB1Longer contractGreater need for specialized investmentOptimal Input ProcurementCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.6-16Contract Length0�1 �0 MB, MC ($)MC0MBShorter contractMore complex contracting