Lecture 8 - Boundaries of the Firm 1 Flashcards
_____ ______ refers to how much of the value chain is owned and controlled by the firm. Ownership can be both in the upstream and downstream part of the value chain
Fill in the blank word
Vetical boundaries
What does horizontal boundaries of a firm refer to?
The degree to which a firm owns companies within the same industry (competitors) or companies in similar industries as a means to pursue diversification
Following are four cases where the firm must make boundary decisions. One of them stands out - which, and why?
A) A defense contractor needs a customized machine essential for completion of a contract, should it customize the machine or make company company take over the task?
B) A specialist is needed to set up a new management info system; should we use an internal employee or temporarily hire an external specialist?
C) A firm needs a steady supply of highly specialized machine parts; how should it secure such supply?
D) A firm needs five reams of copying paper
D) A firm needs five reams of copying paper
This is a standardized transaction with no asset specificity - which makes a significant difference for the nature of the transaction.
In this example, the firm should obviously buy - but in the other cases, the decision considers more evaluation
According to Williamson, transactions in a vertical chain refers to the transfer of a good or service across a technologically separate interface
TRUE/FALSE
TRUE
Within the same industry, it is most often the case that different firms make similar make-or-buy decisions
TRUE/ FALSE
FALSE: make-or-buy decisions are arguably very contingent on the given firm - e.g., Zara frequently uses hierarchy whilst H&M uses the market more often
_____ ______ refers to when a firm internalizes upstream activities, while ____ _____ refers to when a firm internalizes downstream activities
Fill in the blank spaces
BACKWARD INTEGRATION refers to when a firm internalizes upstream activities, while FORWARD INTEGRATION refers to when a firm internalizes downstream activities
Sunk costs are the non-recoverable costs that only have the purpose of a specific transaction
TRUE/FALSE
TRUE
A contract is usually better than a merger because?
A) fewer set-up costs associated with a contractual relation
B) contractual agreements allow sometimes for better specialization
C) mergers are usually better than contractual agreements, not the other way around
A) fewer set-up costs associated with a contractual relation
B) contractual agreements allow sometimes for better specialization
WRONG: C: mergers can be better, but usually are not
According to the Core Ideas of Transaction Cost Economics introduced by Williamson, different governance structures (make or buy) are necessary for handling different transactions because….
A) people are bounded rational
B) people are not always trustworthy, but can be opportunistic
C) economies of scale
D) transactions differ with respect to frequency, uncertainty and asset specificity
A) people are bounded rational
B) people are not always trustworthy, but can be opportunistic
D) transactions differ with respect to frequency, uncertainty and asset specificity
According to Williamson, transactions differ with respect to:
A) bounded rationality exposure
B) frequency
C) asset specificity
D) uncertainty
B) frequency
C) asset specificity
D) uncertainty
A person pursuing ____ ______ focuses on his own interests, but honors agreements and shows respect for others.
Meanwhile, a person that is ________ focuses on own interests and uses all means possible to achieve then (incl. dishonoring agreements, manipulation, cheating, stealing, etc.)
Fill out the blank spaces
A person pursuing SELF-INTEREST focuses on his own interests, but honors agreements and shows respect for others.
Meanwhile, a person that is OPPORTUNISTIC focuses on own interests and uses all means possible to achieve then (incl. dishonoring agreements, manipulation, cheating, stealing, etc.)
In the case of incomplete contracts (where the contract fails to capture all possible contingencies), ex-post bargaining becomes relevant - even when people are not opportunistic and are perfectly rational
TRUE/ FALSE
FALSE: ex-post bargaining becomes relevant only when the contract is incomplete, whilst at least one party is opportunistic and the other party is bounded rational
What does NOT hold true about a complete contract?
A) all relevant future observable contingencies are specified
B) all available information is incorporated into the contract for every situation that could possibly occur
C) assumes that the comprehensiveness of the contract is obtained at no additional costs
D) agents are not opportunistic and perfectly rational
E) most contracts are not complete in reality
WRONG: D) agents are assumed opportunistic, but the principal is assumed to be COMPLETELY RATIONAL
In more complex environments, it is unrealistic to assume that contracts can be designed without costs and that they anticipate every possibility – these situations are better addressed by ______
Fill out the blank space
INCOMPLETE CONTRACTS
Following statement is NOT true about incomplete contracts:
A) contracts become incomplete when there are additional costs associated with writing complex and complete contracts
B) contracts are incomplete when it is not possible to anticipate all possible contingencies
C) contracts may become incomplete when different parties fail to interpret the terms in the same way
D) the agent is assumed opportunistic, and the principal is faced by bounded rationality
E) contracts become incomplete when some terms may be observable but unverifiable by a third-party
All options are true
A contract is complete, when it is at the same time:
A) all information is completely observable by both parties
B) free
C) verifiable by third-party
A contract is complete, when it is at the same time:
B) Free - we assume no transaction costs
C) Verifiable by third-party
WRONG:
A) only in a complete CONTINGENT contract is everything observable - in a complete contract, only the observable things are incorporated into the contract, but not everything is observable
Following incomplete contract theory, agreements that are observable but not verifiable do not constitute a meaningful contract
TRUE/FALSE
TRUE
If asset specificity (AS) is low and transaction frequency is low, then, the firm should: BUY/MAKE
BUY
If asset specificity (AS) is low and transaction frequency is high, then, the firm should: BUY/MAKE
BUY
Why is it that low asset specificity, regardless of transaction frequency, should result in buy rather than make?
A) low asset specificity is well-governed by market exchange since it ensures efficient allocation
B) the market will be efficient at punishing any bad behavior without need for expensive contracts
C) the buy option is sufficient due to abundance of alternative suppliers
D) even if asset specificity is low, the make option is still often the best choice of governance structure
A) low asset specificity is well-governed by market exchange since it ensures efficient allocation
B) the market will be efficient at punishing any bad behavior without need for expensive contracts
C) the buy option is sufficient due to abundance of alternative suppliers
WRONG: D) even if asset specificity is low, the make option is still often the best choice of governance structure
Which statement is NOT true about uncertainty (one of the three determinants for the nature of transactions):
A) says something about the degree of contract incompleteness
B) says something about the possibility for ex-post negotiation of counterparty
C) high uncertainty means that causes for a specific outcome from transaction is har to discover and prove
D) transactions taking place in emerging high-tech industries are likely very uncertain
All options are true
An investment/asset is said to be specific when:
A) the investment has higher value inside a specific relation than outside
B) the investment has no value outside a specific relation
C) when the degree of redeploy-ability for other uses is low
D) part of the cost from investing in the specific asset are sunk
A) the investment has higher value inside a specific relation than outside
C) when the degree of redeploy-ability for other uses is low
D) part of the cost from investing in the specific asset are sunk
Following Williamson (1985), there are several types of asset specificity - which?
A) knowledge asset specificity
B) human asset specificity
C) patented assets
D) physical asset specificity
E) site specificity
F) dedicated assets
G) brand names
B) human asset specificity
D) physical asset specificity
E) site specificity
F) dedicated assets
G) brand names
Human asset specificity refers to:
A) knowledge that is valuable to specific work/tasks arising from an learning-by-doing fashion
B) employees that are only valuable in certain geographies due to the firm’s operations in that location
Human asset specificity: A) knowledge that is valuable to specific work/tasks arising from an learning-by-doing fashion
One type of asset specificity is brand names. This refers to:
A) investing in building a brand that has significant positive reputational impact allowing the firm to be trusted by partners
B) investing in building a brand that has a significant positive impact on the image of the firm’s product, and thus its value
B) investing in building a brand that has a significant positive impact on the image of the firm’s product, and thus its value
Which of the following are examples of physical asset-specificity?
A) machinery that can produce ice-cream packaging but can be adjusted so it produces packaging for other goods too
B) highly customized machine that produces a high-tech computer chip used in Tesla’s new smartphone
C) a very expensive patent developed for a technology necessary for developing flying cars
D) a popcorn machine
B) highly customized machine that produces a high-tech computer chip used in Tesla’s new smartphone
C) a very expensive patent developed for a technology necessary for developing flying cars
Site specific investments entails when ex-ante decisions are made to minimize inventory transportation expenses - and when investment is made, it is infeasible/ very costly to move the investment to another location
TRUE/FALSE
TRUE
What is NOT an example of site-specific investment?
A) wind turbine farm
B) oil-drilling platform
C) airport
D) a law-firm office
D) a law-firm office - this simply entails moving people, since they are the most important “assets” to be moved
Dedicated assets are:
A) assets that derive their value from the prospect of selling a significant quantity to a specific customer - if contract is terminated, significant excess capacity results
B) assets are only useful within a specific time-frame
A) assets that derive their value from the prospect of selling a significant quantity to a specific customer - if contract is terminated, significant excess capacity results
An asset is time-specific if its value is highly dependent on its reaching the user within a specified, relatively limited period of time.
TRUE/FALSE
TRUE
Which of the following is/are not example(s) of time-specific assets
A) flowers
B) take-away
C) sofa
D) newspapers
The “quasi surplus” is defined as
A) the value of the asset investment being non-recoverable for alternative use
B) the value of an investment in its current use minus the value if the investment is in its best alternative use
The “quasi surplus” is defined as
B) the value of an investment in its current use minus the value if the investment is in its best alternative use
Investments in assets with high specificity typically generate no quasi-surplus
TRUE/FALSE
FALSE: since they are not easily redeploy-able, meaning they entail much sunk cost, there will be a stream of quasi-surplus
The allocation of the ex-post surplus depends on the bargaining position of parties, when:
A) contract is incomplete, leaving room for the counterparty to engage in ex-post opportunistic behavior
B) contracts are complete, leaving only bargaining power as determinant for allocation of surplus
The allocation of the ex-post surplus depends on the bargaining position of parties, when: A) contract is incomplete, leaving room for the counterparty to engage in ex-post opportunistic behavior
Fundamental transformation refers to:
The point of investment in the specific asset that is higher within the relationship than outside. This is essentially the point of going from ex-ante to ex-post
The quasi-surplus is calculated as the revenue from best use, minus:
A) sunk costs
B) recoverable costs
C) variable costs
The quasi-surplus is calculated as the revenue from best use, minus:
B) recoverable costs
Quasi-surplus = revenue from best use - recoverable costs
Alternatively:
Quasi-surplus = revenue from best use - (revenue is next-best use - sunk cost)
Firm A develops a specific asset for Firm B.
- Cost of development for A is 200
- Value of the asset to B is 240
- Sunk cost for A is 20
What is the surplus and quasi-surplus respectively?
A) 40 and 60
B) 40 and 20
C) 40 and 40
Surplus: revenue from best use - cost –> 240 -200 = 40
Quasi-surplus = revenue from best use - (revenue is next-best use - sunk cost) –> 240 - (200-20) = 60
The quasi-surplus is always at least as HIGH/LOW as the surplus
The quasi-surplus is always at least as HIGH as the surplus - the difference being the amount of sunk cost
Opportunistic renegotiation after then fundamental transformation is only possible due to ________ and _________
Contract incompleteness/ lacks enforceability; sunk cost
The hold-up problem, referring to ex-post opportunistic renegotiation of contract, results in inefficiency due to:
A) underinvestment
B) overinvestment
The hold-up problem, referring to ex-post opportunistic renegotiation of contract, results in inefficiency due to: A) underinvestment
The hold-up problem can have adverse consequences for transactions - such as:
A) inefficiency due to underinvestment
B) contract negotiations become lengthy/ costly/ tedious
C) distrust and correspondingly limited information flow between parties
D) all of the above
E) two of the above
D) all of the above
Three organizational forms exists relating to different contractual relations - which are these?
A) short-term contracts
B) long-term contracts
C) horizontal integration
D) vertical integration
A) short-term contracts
B) long-term contracts
D) vertical integration
Following is NOT true about short-term contracts as a contractual relation/organizational form:
A) if asset specificity is high, the short term contract makes he ex-post bargaining position poor for supplier
B) it is advantageous for the supplier in cases of high asset specificity
C) is mostly applicable to low-asset-specificity transactions
B) it is advantageous for the supplier in cases of high asset specificity - NO, the opposite is the case
Following hold true for long-term contracts as a contractual relation/ organizational form:
A) large reputational effects, making opportunistic renegotiation unattractive
B) should be chosen when the market exhibits limited uncertainty
C) punishment in perpetuity - that is, never doing business with the opportunistic party again, induces safeguards against ex-post renegotiation
D) such contract is relevant for transactions with asset-specificity to some degree
E) all of the above
D) all of the above
Following hold true for vertical integration - one of the three main organizational forms/ contractual relations:
A) it removes all incentives to hold-up due to internalization of transaction
B) offers safeguards against bad behavior that are not available when using market
C) it is the option of last resort
D) is almost always the most efficient organizational form since it eliminates all opportunistic behavior
Vertical integration
A) it removes all incentives to hold-up due to internalization of transaction
B) offers safeguards against bad behavior that are not available when using market
C) it is the option of last resort
Significant advantages exist for the buy option relative to vertical integration - which?
A) supplier specialization: higher quality and at times less expensive
B) competencies and capabilities may be massively different between focal firm and add-on - limiting the firm’s ability to run add-on acquisition well
C) less up-front capital investment required than hierarchies/ VI
D) is subject to market discipline and free competition
E) all of the above
E) all of the above
One of the advantages of buying (using the market) emerges when the firm’s competencies is very different from those required to run the add-on firm efficiently
TRUE/FALSE
TRUE - Recall the aviation company acquiring the oil company example in class
A fourth additional organizational form/ contractual relation is ______
Hybrid forms: something in-between markets and hierarchy (alliances, JV, etc.)
According to Williamson, the cheapest governance structure is using the market when:
A) assets have low specificity
B) transactions occur very frequently
C) assets have high specificity
According to Williamson, the cheapest governance structure is using the market when:
A) assets have low specificity
According to Williamson, the cheapest governance structure is hierarchy when:
A) assets have low specificity
B) assets have high specificity
C) transactions occur very frequently
According to Williamson, the cheapest governance structure is hierarchy when:
B) assets have high specificity
According to Williamson, the cheapest governance structure is a hybrid form, when:
A) assets have high specificity
B) assets have intermediate level of asset specificity
C) when transactions happen on a daily basis
According to Williamson, the cheapest governance structure is a hybrid form, when:
B) assets have intermediate level of asset specificity
In accordance with the Coase Theorem, market exchange is efficient when there are NO BARGAINING COSTS, regardless of transaction frequency, uncertainty, and asset specificity
TRUE/FALSE
TRUE
