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Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter.

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Presentation on theme: "Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter."— Presentation transcript:

1 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

2 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview I. Methods of Procuring Inputs n Spot Exchange n Contracts n Vertical Integration II. Transaction Costs n Specialized Investments III. Optimal Procurement Input IV. Principal-Agent Problem n Owners-Managers n Managers-Workers

3 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managers 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)

4 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Methods of Procuring Inputs Spot Exchange n When the buyer and seller of an input meet, exchange, and then go their separate ways. Contracts n A legal document that creates an extended relationship between a buyer and a seller. Vertical Integration n When a firm shuns other suppliers and chooses to produce an input internally.

5 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Key Features Spot Exchange n Specialization, avoids contracting costs, avoids costs of vertical integration. n Possible hold-up problem Contracting n Specialization, reduces opportunism, avoids skimping on specialized investments n Costly in complex environments Vertical Integration n Reduces opportunism, avoids contracting costs n Lost specialization, organizational costs

6 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: n Search costs n Negotiation costs n Other required investments or expenditures

7 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 n Site specificity n Physical-asset specificity n Dedicated assets n Human capital Lead to higher transaction costs and the problem of hold-up

8 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Specialized Investments and Contract Length MB 0 MC L0L0 $ Contract Length 0L1L1 MB 1 Longer Contract Due to greater need for specialized investments

9 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 NoNo Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes Contract No

10 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 n Example: Shareholders (principal) cannot observe the effort of the manager (agent) n Example: Manager (principal) cannot observe the effort of workers (agents) The Problem: Principal cannot determine whether a bad outcome was the result of the agents low effort or due to bad luck

11 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Solving the Problem Between Owners and Managers Internal incentives n Incentive contracts n Stock options, year-end bonuses External incentives n Personal reputation n Potential for takeover

12 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


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