The organisation of the firm Flashcards
What are transaction costs?
Costs of negotiating and enforcing agreements
What is specialised investment?
- Expenditure that must be made to allow two parties to exchange but has little or no value in any alternative use
What types of specialised investment are there?
- Site Specificity
- When buyer and seller must locate plants close to each other
- Physical-Asset Specificity
- The capital requirement needed to produce an input is designed to meet the needs of a particular buyer
- Dedicated assets
- investment made by a firm that allow it to exchange with a particular butter
- Human capital
- specific to a transaction
What are the implications of specialised investment?
- Costly bargaining
- Implies only a few parties can pariticapte in this trading
relationship: no other suppliers: no ‘market price’ - Market reference price hard to obtain
- Implies only a few parties can pariticapte in this trading
- Underinvestment
- Level of specialised investment often lower than optimum
- Opportunism and the ‘hold-up problem’
- The buyer or the seller may attempt to capitalise on the ‘sunk’ nature of the investment
What are the options for input procurement?
- Spot Exchange
- Contracts
- Vertical Integration
- Economic Tradeoff
What are the pros/cons of spot exchange?
- Spot market - no contactual relationship
- Competition, Reliability
- But no relationship-specific investment
- Absence of transaction costs, and many buyers and sellers imply imply that the market price is determined by the intersection of demand and supply
- Opportunism can be an issue
- Underinvestment in specialised investments
What are the pros/cons of contracts?
- Use when inputs require a substantial specialised investment
- Typically requires substantial up-front expenditures
- Specifies prices of inputs prior to making specialised investments
- Reduces likelihood of opportunism
- Reduces likelihood to skimp on specialised investmen
- Requires decision on optimal contract length
- Risk of ‘incomplete’ contract
When should vertical integration be used?
- Use when inputs requires
- A substaitonal specialised investment
- Generate signifiant transaction costs
- Complex contracting or uncertain economic environments
What are the pros/cons of vertical integration?
- Advantages
- Skips the middleman
- Reduces opportunism
- Mitigates transaction costs
- Disadvantages
- Managers must create an internal regulatory mechanism
- Bear the cost of setting up production facilities
- No longer specialised in producing its output
- Don’t use when there are benefits from specialisation
What is the principal-agent problem?
- How to compensate labour inputs to put forth maximal effort
How is profit maximisation determined in incentive contracts?
πh = phπG + (1 - ph) πB - yh
What is true of contracts with unobservable effort?
- If effort is not observable, the contract given is not incentive compatible
How are contracts determined with unobservable effort?
- If higher effort is desired, the firm max(yG,yB)π subject to:
- Incentive compatibility constraint
- Participation constraint
What is the Incentive compatibility constriant?
ph √yG + (1-ph) √yB - (eh - 1) ≥ pl √yg + (1-pl) √yB - (el - 1)
What is the participation constraint?
ph √yG + (1-ph) √yB - (eh - 1) ≥ u̅
