Theory of the Firm - Virginia Commonwealth University



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Notes on the Theory of the Firm

Dr. Edward L. Millner

Phone: 828-1717

email: emillner@vcu.edu

URL: people.vcu.edu/~emillner/FastTrack

Primary Learning Objective: Identify the factors which make internal production, spot purchases, or long-term contracts the most efficient means of acquiring an intermediate good or input.

Question: Why do firms exist?

Analysis of cost and production typically based on the presumption that the firm is operating on its production function and cost curves

• If output is produced inefficiently, then actual output is less than the amount indicated by a production function and costs are higher than those indicated by the cost curves.

• Chapter 5 examines some of the crucial decisions the firm faces as it attempts to operate with maximum production efficiency and minimum possible costs

Each firm must address three broad strategic issues relating to its organization.

• How much diversification is optimal?

• How much vertical integration is optimal?

• What compensation scheme is optimal?

Economic analysis of these issues presumes that the firm's answers to each of these questions are motivated by a desire to improve efficiency.

• Diversification occurs when economies of scope exist (one firm can produce two or more goods at lower expense than two or more firms who specialize in the production of each good individually)

• Vertical integration occurs when the expense incurred when a firm produces an input internally is less than the expense incurred when the input is purchased externally

• Compensation schemes will be chosen for their ability to align employees efforts with the interests of the firm

Vertical Integration

• Vertical integration occurs when the firm produces some of its own inputs

• Examples:

o General Motors produces engines and assembles automobiles

o An pulp mill grows trees or engages in logging

o McDonalds supplies franchises and owns and operates retail stores

Three basic means of acquiring inputs exist.

• Buy in spot market

• Buy through long-term contracts

• Produce internally, i.e.; integrate vertically

Question: Conceptual and Computational Question 3

Systematic differences in method of acquiring inputs exist.

|% of products produced internally |Customization of Product |

| |Low |High |

|Complexity of Work |Low |1% |31% |

| |High |2% |92% |

|Masten, Journal of Law and Economics, October 1984, 403-417 |

• Question to be addressed is why the method of acquiring inputs tends to vary systematically.

• Answer by examining the relative efficiencies of using spot markets, long-term contracts, or vertical integration

Purchases in spot market or through long-term contracts involve transactions costs

• Cost of searching for and contacting sellers

• Costs of negotiating price and terms with sellers

• Costs of verifying quality and quantity

• Costs of investments and other expenditures necessary to facilitate exchange

• Specialized investments are sunk; they cannot be recovered in another trading relationship

o Special loading docks

o Retro-fitting assembly lines to accept suppliers' inputs

• Types of specialized investments

o Site specific

o Physical-asset specific

o Dedicated

o Human capital

Question: Conceptual and Computational Question 5

Implications of specialized investments

• Costly bargaining

o Relationship resembles a bilateral monopoly

o No market price exists

o Room for negotiation, threats, and ultimatums

• Underinvestment

o Attempt to avoid being "stuck" with specialized investment

o Exacerbated by perception that the relationship is, or could be, short lived

• Opportunism and "hold-ups"

o Parties are able to take advantage of each other after specialized investments have been made

o Change terms during contract or upon its renewal

Question: Many salespeople at automobile retailers will "haggle" with customers on the car lot but refuse to haggle or even give exact price information over the phone or Internet. Why will these salespeople "deal" only after a customer steps foot onto the car lot? Identity as many reasons as you can.

Homework 1

Best method of acquiring inputs depends upon circumstances

• Spot exchange is typically best when the exchange involves low levels of specialized investments

o Tends to be true for commodities – standardized products sold in competitive markets

o Lets the purchasing firm take advantage of economies of scale when its input use is too small to allow it to achieve full benefits derived from scale

o Lets the firm focus on its core competency - producing and selling its output

• If the exchange involves substantial specialized investments and the ratio of transactions costs of long-term contracts to costs of integration of is low, long-term contracts are typically best

• If the exchange involves substantial specialized investments and the ratio of transactions costs of long-term contracts to costs of integration of is high, vertical integration is typically best

Question: Suppose that you manufacture motorboats and agreed two years ago to purchase 100,000 motors from Johnson Motor company for $1000 per motor. Feeling that you were protected from opportunism, you customized your boat design to accommodate the Johnson motors. Now Johnson finds itself on the verge of bankruptcy and says that it will go broke unless you pay $1,500 per motor.

a. Was the decision to contract a bad one?

b. What should you do?

c. Should this situation have been avoided?

Contracts need not be written

• Informal contracts are often effective and more efficient than formal contracts

• Buyers can punish opportunistic sellers

o Take future business elsewhere

o Spread the word to create a bad reputation effect

Vertical integration is not a panacea

• Internal regulation may not be as effective as market discipline to reduce cost

• May distract firm from doing what it does best

Economies of scope and the nature of the production process may also dictate that vertical integration is optimal

Question: Conceptual and Computational Questions 1, 2, 4, 8

Question: Problem and Application 10 and 17

Question: Use the principles developed in class to explain the increased use of outsourcing for delivery services, accounting, information technology, and customer service.

The optimal length of a contract makes the marginal benefit of a slightly longer contract equal to the marginal cost of the extension

• Additional length increases uncertainty and potential hazards that require resolution

• Additional length reduces chances for opportunism

• An increase in specialized investments increases the marginal benefit of a contract and increases the optimal length of the contract

• Complexity and uncertainty increase the marginal cost a contract and decreases the optimal length of the contract

o More points to negotiate

o More likely that the contract will fail to specify responsibilities for an event

o More likely that one party will try to renege

o Trying to use a series of short-term contracts increases bargaining costs and legal fees

• If the optimal length is too short, the disadvantages of negotiating a series of short-term contracts outweigh the costs of internal production

Question: Problems and Applications 9 and 14

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