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Organization of Firm
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Learning Objectives:
• How do firms hire inputs of production?
• What are transaction costs?
• What is the Principal-Agent problem?
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How can a firm hire inputs?
• Spot Exchange: Purchasing inputs as requirements arise, without any continual obligation
• Contract: Legally binding continual exchange between the firm and the input suppliers
• Vertical Integration: Production of inputs internally
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Transaction Costs
• Transaction Costs are the excess costs incurred for acquiring inputs other than the prices of inputs.
• Two types: • Search cost • Matching cost
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Specialized Investment and relationship-specific Exchange
• Specialized investments are non-transferable investments to facilitate a relationship-specific exchange
• Types of specialized investments • Site specificity • Physical asset specificity • Dedicated assets • Human capital
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Specialized Investments and Transaction Costs
• Costly Bargaining
• Underinvestment
• Opportunism
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Optimal Input Procurement
• It is firm specific and depends on the features of a particular production process, legal environment, and overall economic situation.
• Example: ATMs and a Rising Number of Bank Tellers?
• Example: Outsourcing at Ericsson
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Principal-Agent Problem
• When ownership is separated from control, how do the owners monitor their employees, and ensure that they are putting the maximum effort?
• How does a manager ensure that employees are not shirking?
• Solution: Devise an incentive mechanism
• Example: Jack Welch and General Electric