1. Economics of Management Strategy BEE3027 Miguel Fonseca Lecture 1

2. Some background Where can you find the relevant course material for this half of the course? http://people.ex.ac.uk/maf206/ems.htm Most lectures will have an accompanying problem set and reading list. We will use the second hour to answer and discuss problem sets from previous weeks.

3. Some background Problem sets will give you a flavour of what to expect in the exam. They will mainly be problem solving questions although I may include some essay questions. If you have any questions outside class, my office hours are: –13:30 to 15:30 on Mondays

4. A roadmap for this half of the course In this half of the course, we shall look at how economists think about the firm: –Why does it exist? –How is it organised? –What kind of incentive structures can be in place for employees? –What is the economics behind the pricing and marketing strategies available to firms? –How do firms evaluate projects? –What are the issues regarding a firm’s corporate control and financial structure?

5. Neoclassical theory of the firm Traditionally economists look at the firm as a black box. For a given set of inputs, it produces a set of outputs. No explanation is given for why it exists and what limits there are for firms, either in scale or in scope.

6. Cost concepts Opportunity cost –Value of the factor in its next best alternative use Economic costs of durable inputs –e.g. Depreciation Avoidable costs vs. sunk expenditures Short run vs. long run –In SR, some inputs are fixed (e.g. building) –In LR, all inputs are variable → all costs avoidable; Variable and fixed costs

7. Economies of scale Economies of scale refer to the relationship between a firm’s output and cost function: –They occur when the long-run average cost declines as output rises. They exist due to indivisibilities. –(Long-Run) Fixed Costs; –Setup costs; –Specialised resources; –Volumetric returns to scale/economies of massed reserves;

8. Economies of scale

9. Economies of scope Another advantage of being large is that one is able to produce more than one good based on a given set of (common) inputs. If two different goods require similar production technology (e.g. cars and trucks), a firm may take advantage of a large production facility. Formally, in the two good case, economies of scope exist if: C(q1, q2) < C(q1, 0) + C(0, q2)

10. Why do firms exist? So far, neo-classical economics tells us nothing about why firms exist. Coase (1937) was the first economist to pose this question. –He argues that the defining feature of the firm is that production is organised by command. –If market exchange is efficient, why aren’t all firm activities outsourced to market agents?

11. What is the optimal firm size? Coase also wondered what determines firm size. His argument was: –if firms exist, there must be an advantage to produce under such structures! –Therefore, why not organise production by one very large firm?

12. Transactions cost The key to answering both questions lies in transaction costs. Although economic theory assumes (in the vein of Physics) that real-world markets are frictionless, there are a number of issues that permeate transactions. Hence, firms will choose the modus operandi which minimise these transaction costs.

13. Alternative Economic Organisations Before elaborating on the notion of transaction costs, let us consider three basic forms of organising production processes: 1.Spot markets; 2.Long-term contracts; 3.Vertical integration.

14. Dimensions of Transactions Asset Specificity Frequency and Duration Complexity and Uncertainty Difficulty of Performance Measurement Connectedness to other Transactions

15. Asset specificity In most business relationships, both supplier and firm make specific investments to maximise profits (e.g. building a production line). The degree of asset specificity is a function of its alternative uses, what economists call Quasi-Rents. Quasi-Rent = value of asset in its current use – value of asset in its next-best use. The more specific the asset, the lower the value in its next-best alternative use, and the higher its quasi-rent will be.

16. Asset specificity Physical-Asset specificity Site specificity Human-Asset specificity Dedicated Assets

17. Asset specificity The higher the degree of asset specificity, the more attractive in-house production will be vis- à-vis outsourcing. One of the main reasons for this is what economics calls the ‘hold-up problem’.

18. Hold-up problem Relationship-specific investments also change the relationship between supplier and buyer. Once these investments are made by one of the parties, there is scope for opportunistic behaviour by the other party. That is, the other party has an incentive to re- negotiate the contract, and extract some or all of the other firm’s quasi-rents.

19. Hold-up problem: example Consider the case of a soft drink company. Cost of bottles: Cb = TVB + F, where –TVB is the total variable cost of making bottles –F is the Fixed cost of the machines needed. If bottle making market is perfectly competitive, the winning bid for a contract would specify a price = Avg cost => 0 profits for bottle maker.

20. Hold-up problem: example Assume: –R is revenue from water sales; –TVP is variable cost of producing soft drinks; –S is the salvage value from re-selling bottle making machinery.

21. Hold-up problem: example Gains from trade between two firms are: –V = R – TVP – TVB If firms decide to part ways, they must look for alternative trading partners. –Bottle maker could sell machinery for S. Its quasi- rents are F – S. –The water company must spend F and T to search for new supplier. Its profit would be V – F – T. Its quasi-rent would be (V – F) – (V – F – T) = T.

22. Hold-up problem: example The outside option would be to terminate relationship, yielding the following surplus: –O = (V – F – T) + S They will continue relationship as long as it is more profitable than switching, i.e. if V – O > 0. –V – O = V – ((V – F – T) + S) = F – S + T F – S is the amount accrued to the supplier T is the amount accrued to the firm.

23. Hold-up problem: example If F – S + T > 0, there is a financial basis for a long-term relationship. Terminating the relationship yields losses equal to the quasi-rents. However, once the agreement is signed, both parties have an incentive to renegotiate!

24. Hold-up problem: example The firm can claim “production costs have risen” and offer to pay S + £0.01 + TVB instead of F + TVB. If supplier rejects offer, it can recoup S. If it accepts, it receives S+£0.01. Alternatively, the supplier can also try to renegotiate by requiring F + T - £0.01 + TVB, as opposed to original F + TVB.

25. Hold-up problem As shown in the example, both sides to the transaction may have an incentive to renegotiate the terms of the contract. When successful, this results in the redistribution of the quasi-rents inherent to the transaction. The more asset-specific the investment by both parties, the more likely this is to happen.

26. Contracts We have just seen what are the circumstances under which people may be reluctant to acquire production inputs through spot markets. An obvious solution to the previous example would be for the two parties to write down a contract where they specify the price to be paid. So why not use contracts exclusively?

27. Complete vs. Incomplete Contracts Complete contract: –A contract which perfectly specifies a distribution of the gains of trade for every possible contingency and which is perfectly enforceable, without need of revision. Most contracts must be negotiated, updating and enforced. The costs associated with such activities are called transaction costs.

28. Transaction Costs Even if a complete contract were to be drawn up, it would still imply transaction costs: –Figuring out all possible contingencies; –Reaching an agreement on for each of the above; –Writing the contract in acceptable terms; –Monitoring costs; –Enforcement costs (e.g. lawyer fees). This means real-world contracts are incomplete

29. Transaction Costs The more complex the transaction, the higher the costs of drawing up a contract. The possibility of hold-up also makes firms allocate resources to non-productive activities, which yield inefficiencies: –Writing and renegotiating complex contracts; –Monitoring and preventing hold up Making investments to prevent being locked in to one supplier; –Underinvestment in specific assets.

30. Transaction Costs Of course, contracts can also be a source of hold up! If firms are tied in long-term contracts, if economic conditions change, the party who is better off has no incentive to renegotiate. So, the other alternative for production is to vertically integrate the production chain.