ECO 610-401

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ECO 610-401

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

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Exam Distribution
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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.

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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

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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

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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.

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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

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The Determinants of Architecture
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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

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Make or Buy Continuum
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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.

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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.

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An Example Rustic Homes
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Rustic Log Cabin (2)

• Cabin cost 10,000 each
• Costs include
• Labor (4,000)
• Lumber
• 7,000
• 5,000
• 3,000
• 100 confirmed orders

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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?

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Rustic Log Cabin (4)
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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

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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

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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

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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.

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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 Pm giving revenue of
  1,000,000Pm

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Rents and Quasi-Rents (2)

• Suppose Pm gt C then ignoring I, profit is
  1,000,000(Pm-C) but
• I gt 1,000,000(Pm-C) then
• I - 1,000,000(Pm-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 Pm 4 then RSI
  8,500,000 1,000,000(4-3) 7,500,000
• Suppose Ford will pay P gt Pm
• Rent is 1,000,000(P-C) I, profit you expect

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Rents and Quasi-Rents (3)

• Quasi-Rent
• Suppose the deal with Ford falls through
• I is a sunk cost and sell to Jobbers if PM gt C
• Quasi-Rent 1,000,000(P-C)-I -
  1,000,000(PM-C)-I 1,000,000(P-PM)
• Extra profit if deal goes through

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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, PM 4, C 3, I 8,500,000
• At P12, 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

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