Lecture 10 Economic Theory of the Firm

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Lecture 10Economic Theory of the Firm

• There are two views of the firm
• 1. Neoclassical (traditional) theory
• Firm is a calculating entity, that makes
  decisions, buys inputs, making output, and
  selling for profit for loss
• 2. Property rights theory
• Firm is a collection of contracts between owners
  of resources, who wish to combine portions of
  their resources, for some period, for some purpose

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Traditional Theory of the Firm

• Traditionally, the firm headed by the
  entrepreneur or manager makes decisions
• What to produce?
• When and how to produce it?
• How much to produce?
• What is its price?
• The firm is seen as having a production function
• Relates inputs and outputs like a recipe
• q q (x,y,z)
• q is output
• x, y, z are inputs
• The exact form depends on technology, etc.

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A production function

• A production function is often a mechanical view
  of production
• 1 shovel of cement
• 3 shovels of sand
• 5 shovels of stone
• 4 liters of water
• Use labor to mix cement, sand, and stone for 1
  minute
• Add more water to get right texture
• Use labor to mix ingredients for 2 minutes
• Output 12 liters of wet concrete
• Most of this is engineering. The role of
  economics is limited to the importance of price,
  substitutes, etc. Important concepts, but not
  difficult to grasp.

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Property Rights Theory Firms and Markets

• The tradeoff
• Market is informationally efficient
• The firm is contractually efficient
• The balance between these two determines the
  methods of production chosen by an entrepreneur
  or manager

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What Kind of Organizational Form to Choose?

• A key role of managers is to procure inputs in
  the least cost manner.
• If not accomplished, costs will be higher than
  needed and the firm will lose profits and perhaps
  go bankrupt.
• Basic Question To achieve greater efficiency,
  does a manager procure inputs from the market or
  procure inputs within the firm?

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How to obtain needed inputs?

• Consider possible stages of production
• Obtaining raw materials
• Obtaining finished parts
• Assembly
• Transportation services
• Storage
• Wholesaling
• Retailing

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How to obtain needed inputs?

• General services needed by a firm
• Accounting
• Finance (including credit service)
• Human Resources
• Legal Services
• Marketing (advertising, etc.)
• Janitorial Service
• Who is to provide such services?

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Who provides needed services and materials?

• Should the firm produce within the organization
  or buy from the outside?
• There is no one answermany conditions will
  determine outcome.
• Think of the great range of options
• Spot markets ? Long Term Contracts ?
• Vertical Integration (produce in house)

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Inputs Can Be More Costly than Necessary

• Study of a ship building firm showed transaction
  costs were 14 of the total cost of construction.
• Wrong decisions about how to obtain inputs are
  costly.
• Some internal inputs that could have been bought
  for less from outside increased cost as much as
  70.
• External purchases that could have been done
  in-house for less increased cost as much as 300.

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Methods of Obtaining Inputs

• 1. Spot market or spot exchange
• Buyers and sellers exchange, but might not deal
  again.
• Benefits deal with specialized sellers, who
  often have economies of scale not possible within
  the firm, and usually low transaction costs. The
  provider is not integrated into the firm.
• Possible problems Exploitation by seller who
  knows we are ignorant inconsistent quality lack
  of internal coordination. Information leaks to
  competitors.
• Products involved are usually generic.

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Methods of Obtaining Inputs

• 2. Contracts
• Legally based extended relationship between
  buyer and seller.
• Benefits Specialization ability to terminate
  sellers who do not perform reduction in
  exploitation compared to spot markets.
• Problems Costly in complex environments
  difficult to specify quality exactly and to
  measure quality unforeseen problems including
  liability issues.

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Contracting Complexity Ford

• Ford used annual bidding competition to achieve
  low cost suppliers for auto parts (7 billion a
  year).
• Problems high administrative cost, bankruptcy by
  suppliers (Delphi), quality control uneven
• Solution multi-year contracts with fewer
  suppliers (down from 2,500 to 1,000) closer
  working relationship estimated savings of 10
  per year.

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Many Forms of Contracts

• Services (Deere and Ryder Trucks UPS and
  Toshiba warranty laptop repairs UPS and Jockey
  Japanese call centers in Dalien)
• Joint Ventures (foreign firms in China)
• Leases (office buildings)
• Franchises (McDonalds, car dealers)
• Strategic Alliances (Merck Astra)

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Politics May Help Force Form

• McDonalds in Japan was run by politically
  well-connected Japanese company (JMcD).
• Toys R Us (Toys) wanted to enter Japan but
  bureaucrats stopped it.
• Alliance between JMcD and Toys took care of
  politics and found natural benefitsJMcD knew the
  Japan real estate and customer market well. Every
  Toys store had JMcD in it. JMcD as profit partner
  had strong incentive to help Toys be successful.

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Methods of Obtaining Inputs

• 3. Vertical Integration
• (Non-market relations)
• When a firm chooses to produce an input
  internally rather than contract with outsiders.
• Benefits Reduced opportunistic behavior by
  outsiders and fewer contracting costs.
• Problems Lost specialization, locked into
  certain method of production, and increased
  organizational (managerial) costs.
• Inputs are usually highly specialized.

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When Is Vertical Integration More Likely to Be
Necessary?

• To protect brand name. Examples Sony, Prada
• When there are specific assets or high sunk
  costs. Examples pipeline GM-Fisher refinery.
• Consider Is it risky for an employee to become
  asset specific to a particular employer?
• When economies of scale changesCoke and Pepsi
  now own most bottling plants and control national
  marketing strategy.
• When coordination critical stages of health care.

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Multiple Forms May Exist

• About 20 of gasoline in U.S. is sold at stations
  owned by refiners (this share growing). Other 80
  of gasoline sold by other companies.
• Why not all one way or the other?
• Refiners control retail price at their stations,
  but cannot control independentscan prevent price
  gouging by independents.
• Company owned stores tend to be huge stations not
  offering repair services or other specialized
  services done better by independents who will
  work to protect their personal reputation.

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Forward or Backward Integration

• ForwardA company that owns a coal mine builds a
  power plant to generate electricity.
• BackwardAn electric company buys a coal mine to
  guarantee supply.
• When the two are close to each otherusually
  integrate into one firm. Specific
  investmentsboiler design tied to coal type.
• When utility not near coal mine long term
  contracts with suppliers usually relied upon.
• Why not short term or spot contract?

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Integration in Insurance Industry

• Whole life often sold through in-house sales
  force. The company holds the key asset (list of
  clients). To get agents to work hard the
  commissions are frontloadedbig at time of first
  sale.
• Fire and casualty insurance usually sold through
  independent brokers. The brokers hold the key
  assets (list of clients). To keep them tied to
  insurance company, the commissions are
  backloadedrenewal commission every year.

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Methods of Obtaining Inputs

• Summary
• Are there specialized investments relative to
  contracting costs? If nolikely to use spot
  market.
• If yesis the cost of contracting high relative
  to the cost of integration? If yesvertical
  integration if nocontracts with outside
  suppliers.
• Think about chickens (or spinach).