CHAPTER 6

The Organization of the Firm

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 Learning Objective
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how
each can lead to costly bargaining, underinvestment, and/or a
“hold-up problem.”
3. Explain the optimal manner of procuring different types of inputs.
4. Describe the principle-agent problem as it relates to owners and
managers.
5. Discuss three forces that owners can use to discipline managers.
6. Describe the principal-agent problem as it relates to managers and
workers.
7. Discuss four tools the manager can use to mitigate incentive
problems in the workplace.
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 Introduction

Management’s Role
Producing at Minimum Cost
Costs Minimum
($) cost function

$100 A

B
$80

0 10 Output

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 Methods of Procuring Inputs

Methods of Procuring Inputs

• Spot exchange(hối đoái giao ngay)
– An informal relationship between a buyer and seller in
which neither party is obligated to adhere to specific
terms for exchange. (Ko bên nào có nghĩa vụ phải tuân
thủ các điều khoản…)
• Contract(hợp đồng)
– A formal relationship between a buyer and seller that
obligates the buyer and seller to exchange at terms
specified in a legal document.
• Produce inputs internally (vertical integration)
– A situation where a firm produces the inputs required
to make its final product.
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 Methods of Procuring Inputs

Methods of Procuring Inputs In Action

• Determine whether the following transactions involve spot
exchange, a contract, or vertical integration:
– Clone 1 PC is legally obligated to purchase 300 computer chips each
year for the next 3 years from AML. The price paid in the first year is
$200 per chip, and the price rises during the second and third years
by the same percentage by which the wholesale price index rises
during those years.
– Clone 2 PC purchased 300 computer chips from a firm that ran an
advertisement in the back of a computer magazine.
– Clone 3 PC manufactures its own motherboards and computer chips
for its personal computers.
• Answers:
– Clone 1 PC is using a contract.
– Clone 2 PC used the spot exchange.
– Clone 3 PC uses vertical integration.
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 Transaction Costs
Transaction Costs
(chi phí giao dịch)

• Cost associated with acquiring an input that is

in excess of the amount paid to the input
supplier.
• Types of “obvious” transaction costs
– Cost of searching for a supplier.
– Cost of negotiating a price.
– Investments and expenditures required to
facilitate exchange.

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 Transaction Costs

Types of “Hidden” Transaction Costs

• Specialized investment
– Expenditure that must be made to allow two
parties to exchange but has little or no value in
any alternative use.
• Relationship-specific exchange
– A type of exchange that occurs when the parties
to a transaction have made specialized
investments.

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 Transaction Costs

Types of Specialized Investments

• Types of specialized investments
– Site specificity
– Physical-asset specificity
– Dedicated assets
– Human capital

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 Transaction Costs

Implications of Specialized
Investments
• Implications of specialized investments
– Costly bargaining
– Underinvestment
– Opportunism and the “hold-up problem”

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 Optimal Input Procurement
Optimal Input Procurement
• How should a manager acquire inputs to
minimize costs?
– Depends on the extent of the relationship-specific
exchange.

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 Optimal Input Procurement

Spot Exchange
• Characteristics of the spot exchange:
– No relationship-specific investment.
– Absence of transaction costs, and many buyers
and sellers, imply that the market price is
determined by the intersection of demand and
supply.
– Opportunism
– Underinvestment in specialized investments

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 Optimal Input Procurement
Contracts
• Characteristics of contracts:
– Use when inputs require a substantial specialized
investment.
– Typically requires substantial up-front
expenditures.
– Specifies prices of inputs prior to making
specialized investments.
• Reduces likelihood of opportunism.
• Reduces likelihood to skimp on specialized investment.
– Requires decision on optimal contract length.

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 Optimal Input Procurement

Optimal Contract Length

MB, MC MC
($)

MB

0  𝐿∗ Contract Length

(in years)

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 Optimal Input Procurement

Specialized Investments and

MB, MC
Contract Length
($) MC

MB1
Greater need for
specialized investment
MB0

0  𝐿0  𝐿1 Contract Length

Longer contract

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 Optimal Input Procurement
Contracting Environment and Contract
LengthMC MC MC 1 0 2
MB, MC
($)
More complex
Less complex
contracting
contracting
environment
environment

MB

0  𝐿1  𝐿0  𝐿2 Contract Length

Shorter contract Longer contract

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 Optimal Input Procurement

Vertical Integration
• Produce inputs internally
• Use when inputs require
– a substantial specialized investment.
– generate significant transaction cost.
– complex contracting or uncertain economic environments.
• Advantages:
– “Skips the middleman”
– Reduces opportunism
– Mitigates(giảm thiểu) transaction costs
• Disadvantages:
– Managers must create an internal regulatory mechanism (phải tạo cơ
chế điều tiết nội bộ)
– Bear the cost of setting up production facilities
– No longer specialized in producing its output
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 Optimal Input Procurement

Optimal Procurement of Inputs

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 Managerial Compensation and the Principal Agent Problem

Managerial Compensation and the

Principal-Agent Problem
• The primary obstacle is the separation of
ownership and control.
– Principal-agent (P-A) problem: if the owner is not
present to monitor the manager, how can she get the
manager to do what is in her best interest?
– Owners have to incent (khuyến khích )managers since
they are not present to monitor.

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 Managerial Compensation and the Principal Agent Problem

Managers’ Compensation Mechanisms

• Manager’s economic trade-off
– Leisure.
– Labor
• Fixed salary
– Receives wage independent of labor hours and effort.
• No strong incentive to monitor other employees labor hours and
effort.
• Adversely impacts firm performance.
• Incentive contract
– Tie manager wage to firm performance (like profits).
– Manager makes labor-leisure choice and is accordingly
compensated.
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 Forces that Discipline Managers

Incentive Contracts
• A way to align owners’ interests with that of
the actions of its manager.
• Examples include:
– Stock option
– Other bonuses directly related to profits.

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 Forces that Discipline Managers

External Incentives
• Outside forces can provide manages with the
incentive to maximize profits, and include:
– Reputation
– Takeover threat

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 The Manager-Worker Principal-Agent Problem
The Manager-Worker
Principal-Agent Problem
• The owner-manager, principal-agent problem
is not unique.
– A similar problem exists between the firm’s
managers and the employees he or she
supervises.

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 The Manager-Worker Principal-Agent Problem

Solutions to the Manager-Worker

Principal-Agent Problem
• Manager-worker principal-agent problem
solutions:
– Profit sharing
– Revenue sharing
– Piece rates (dựa trên tỷ lệ sản phẩm)
– Time clocks and spot checks

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 Conclusion
• The optimal method for acquiring inputs
depends on the nature of the transaction
costs and specialized nature of the inputs
being produced.
• To overcome the owner-manager and
manager-worker principal-agent problems,
principals must align the agents’ interests with
the principals’ interests.

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