1. ECO 610-401 Monday, December 1 st –Organizational Design: Centralized vs. Decentralized –Readings, Brickley et al., 11-13 Monday, December 8 th –Performance Measures Readings, Brickley et al., 16 –Extended Assignment 3 due

2. Exam Distribution

3. Organizational Architecture Any complex firm or organization must address: The assignment of decision rights within the firm The method of rewarding individuals The structure of systems to evaluate the performance of both individuals and business units.

4. The Fundamental Problem Produce output customers want at the lowest cost The answer to this challenge is complicated by: –Information held by different parties –Information is expensive to transfer (specific rather than general) –Asymmetric information (workers and supervisors dont have the same information – principal agent problem) –Incentive Problems

5. The Market Solution With Markets individuals have property rights Prices: –Are a signal –Give incentives –Promote economic efficiency Decisions tend to be made by individuals with specific knowledge

6. Architecture within the Firm No Automatic Systems for: –Assigning decision rights to individuals with information –Motivating individuals with information to use them to promote a firms objectives Decision Rights: –Most firms by Administrative Decision rather than Prices –Grant authority to have control of firm resources by employees not owners Since employees are not owners, have fewer incentives to use resources efficiently.

7. Architecture within the Firm (2) Controls –Necessary to control incentive problems –Consist of: Reward and performance evaluation Tradeoffs –In larger firms, CEO cant know and do all IF CEO makes decisions will lack information If CEO tries to get information, will be costly If CEO delegates decisions to those with information, incentive problems arise

8. The Determinants of Architecture

9. Vertical Integration and the Make or Buy Decision What determines when a firm should make (vertically integrate) or buy (outsource)? Examined in the simple transfer pricing framework, now add some other considerations

10. Make or Buy Continuum

11. Make or Buy Fallacies 1.Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for the firm 2.Firms should buy, rather than make, to avoid the costs of making the product. 3.Firms should make, rather than buy, to avoid paying a profit margin to independent firms. 4.Firms should make, rather buy, because a vertically integrated producer will be able to avoid paying higher market prices for the input during periods of peak demand or scarce supply. 5.Firms should make to tie up a distribution channel. They will gain at the expense of rivals.

12. Benefits and Costs of Using the Market Benefits Market firms can achieve economies of scale that in-house departments cannot. Market firms are subject to the discipline of the market and must be efficient and innovate to survive. Overall corporate success may hide the inefficiencies and lack o innovation of in-house markets. Costs Coordination of production flows through the vertical chain may be compromised when activity is purchased from outside vendor. Private information may be leaked. There may be costs of transacting with independent market firms that can be avoided by performing the activity in-house.

13. An Example: Rustic Homes

14. Rustic Log Cabin (2) Cabin cost $10,000 each Costs include –Labor ($4,000) –Lumber $7,000 $5,000 $3,000 –100 confirmed orders

15. Rustic Log Cabin (3) Rustic Cabin is considering 2 options: –Buy lumber from mill –Purchase forest land and mill for annual bank payment of $350,000 ($3,500 per cabin) Cost of milling is $1,500 Effective cost of lumber is $5,000 per cabin Other Options?

16. Rustic Log Cabin (4)

17. Reasons to Buy Exploiting Scale and Learning Economies Agency Costs –Cost Centers do not face market pressures difficult to measure performance Influence Costs –Scarce capital and resources in a firm are bid by competing divisions Lobbying is a waste of resources Inappropriate allocations as a result

18. Reasons to Make Reasons to make are associated with the costs associated with writing and enforcing contracts Complete versus Incomplete Contracts –Complete contract eliminates opportunistic behavior –Requires knowledge and agreement on all contingencies –Requires enforcement by outside party The problems arise with contracts because of –Bounded rationality –Difficulties specifying or measuring performance –Asymmetric Information

19. Reasons to Make (2) Leakage of Private Information Transaction Costs Relation-Specific Assets –Value of assets depends on the relationship – value of assets diminishes if relationship is severed. –Types of Asset Specificity: Size Specificity Physical Asset Dedicated Assets Human Asset Specificity

20. The Fundamental Transformation Need to create relation-specific assets transforms relationships as the transaction unfolds. –Before the transactions, firms can choose the most profitable partnership –After the transaction they will have few alternatives.

21. Rents and Quasi-Rents Example: Cup Holders for Ford Taurus 1,000,000 holders with average variable cost of C per unit Factory is constructed with loan with interest of I per year. TC = I + 1,000,000C Expect Ford to buy. If not sell to jobbers to resell at price of P m giving revenue of 1,000,000P m

22. Rents and Quasi-Rents (2) Suppose P m > C then ignoring I, profit is 1,000,000(P m -C) but I > 1,000,000(P m -C) then I - 1,000,000(P m -C) represents relation-specific investment (RSI) –Amount of investment firm cannot recover if it doesnt do business with Ford If I = $8,500,00, C = 3, and P m = 4 then RSI = 8,500,000 – 1,000,000(4-3) = 7,500,000 Suppose Ford will pay P* > P m Rent is 1,000,000(P*-C) – I, profit you expect

23. Rents and Quasi-Rents (3) Quasi-Rent –Suppose the deal with Ford falls through –I is a sunk cost and sell to Jobbers if P M > C –Quasi-Rent = [1,000,000(P*-C)-I] - [1,000,000(P M - C)-I] = 1,000,000(P*-P M ) Extra profit if deal goes through

24. The Hold-Up Problem If Quasi-Rent is large, firm has a lot to lose in second- best alternative. This gives the possibility of hold-up through renegotiation when contractions are incomplete Example: P* = 12, P M = 4, C = 3, I = 8,500,000 At P*=12, Rent is 500,000 per year Quasi-Rent is (12-4)1,000,000 = 8,000,000 If Ford renegotiates down to $8, it increases its profits by $4,000,000 You lose (8-3)1,000,000-8,500,000=-3,500,000