Economic Theory of the Economic Theory of the FirmFirm

There are two views of the firm:There are two views of the firm:

1. Neoclassical (traditional) theory:1. Neoclassical (traditional) theory: Firm is a calculating entity, that makes Firm is a calculating entity, that makes

decisions, buys inputs, making output, decisions, buys inputs, making output, and selling for profit for lossand selling for profit for loss

2. Property rights theory:2. Property rights theory: Firm is a collection of contracts between Firm is a collection of contracts between

owners of resources, who wish to combine owners of resources, who wish to combine portions of their resources, for some portions of their resources, for some period, for some purposeperiod, for some purpose

Traditional Theory of the Traditional Theory of the FirmFirm

Traditionally, the firm — headed by the Traditionally, the firm — headed by the entrepreneur or manager — makes decisions:entrepreneur or manager — makes decisions:– What to produce?What to produce?– When and how to produce it?When and how to produce it?– How much to produce?How much to produce?– What is its price?What is its price?

The firm is seen as having a production function:The firm is seen as having a production function:– Relates inputs and outputs — like a recipeRelates inputs and outputs — like a recipe

q = q (x,y,z)q = q (x,y,z) q is outputq is output x, y, z are inputsx, y, z are inputs

– The exact form depends on technology, etc.The exact form depends on technology, etc.

A production functionA production function

A production function is often a mechanical view A production function is often a mechanical view of production:of production:– 1 shovel of cement1 shovel of cement– 3 shovels of sand3 shovels of sand– 5 shovels of stone5 shovels of stone– 4 liters of water4 liters of water– Use labor to mix cement, sand, and stone for 1 Use labor to mix cement, sand, and stone for 1

minuteminute– Add more water to get right textureAdd more water to get right texture– Use labor to mix ingredients for 2 minutesUse labor to mix ingredients for 2 minutes– Output: 12 liters of wet concreteOutput: 12 liters of wet concreteMost of this is engineering. The role of economics Most of this is engineering. The role of economics

is limited to the importance of price, is limited to the importance of price, substitutes, etc. Important concepts, but not substitutes, etc. Important concepts, but not difficult to grasp.difficult to grasp.

Property Rights Theory: Property Rights Theory: Firms and MarketsFirms and Markets

The tradeoff:The tradeoff:– Market is informationally Market is informationally

efficient efficient – The firm is contractually The firm is contractually

efficientefficient

The balance between these two The balance between these two determines the methods of determines the methods of production chosen by an production chosen by an entrepreneur or managerentrepreneur or manager

What Kind of Organizational What Kind of Organizational Form to Choose?Form to Choose?

A key role of managers is to procure A key role of managers is to procure inputs in the least cost manner.inputs in the least cost manner.

If not accomplished, costs will be higher If not accomplished, costs will be higher than needed and the firm will lose than needed and the firm will lose profits and perhaps go bankrupt.profits and perhaps go bankrupt.

Basic Question: To achieve greater Basic Question: To achieve greater efficiency, does a manager procure efficiency, does a manager procure inputs from the market or procure inputs from the market or procure inputs within the firm?inputs within the firm?

How to obtain needed How to obtain needed inputs?inputs?

Consider possible stages of Consider possible stages of production:production:Obtaining raw materialsObtaining raw materialsObtaining finished partsObtaining finished partsAssemblyAssemblyTransportation servicesTransportation servicesStorageStorageWholesalingWholesalingRetailingRetailing

How to obtain needed How to obtain needed inputs?inputs?

General services needed by a firm:General services needed by a firm:

AccountingAccounting

Finance (including credit service)Finance (including credit service)

Human ResourcesHuman Resources

Legal ServicesLegal Services

Marketing (advertising, etc.)Marketing (advertising, etc.)

Janitorial ServiceJanitorial Service

Who is to provide such services?Who is to provide such services?

Who provides needed Who provides needed services and materials?services and materials?

Should the firm produce within the Should the firm produce within the organization or buy from the outside?organization or buy from the outside?

There is no one answer—many There is no one answer—many conditions will determine outcome.conditions will determine outcome.

Think of the great range of options:Think of the great range of options:

Spot markets Spot markets → Long Term Contracts →→ Long Term Contracts →

Vertical Integration (produce in house)Vertical Integration (produce in house)

Inputs Can Be MoreInputs Can Be More Costly than Necessary Costly than Necessary

Study of a ship building firm showed Study of a ship building firm showed transaction costs were 14% of the total cost transaction costs were 14% of the total cost of construction.of construction.

Wrong decisions about how to obtain inputs Wrong decisions about how to obtain inputs are costly.are costly.

Some internal inputs could have been bought Some internal inputs could have been bought for less from outside increased cost as much for less from outside increased cost as much as 70%.as 70%.

External purchases that could have been External purchases that could have been done in-house for less increased cost as done in-house for less increased cost as much as 300%.much as 300%.

Methods of Obtaining Methods of Obtaining InputsInputs

1.1. Spot market or spot exchange—Spot market or spot exchange—Buyers and sellers exchange, but might Buyers and sellers exchange, but might not deal again. not deal again.

Benefits: deal with specialized sellers, who Benefits: deal with specialized sellers, who often have economies of scale not possible often have economies of scale not possible within the firm, and usually low within the firm, and usually low transaction costs. The provider is not transaction costs. The provider is not integrated into the firm. integrated into the firm.

Possible problems: Exploitation by seller who Possible problems: Exploitation by seller who knows we are ignorant; inconsistent knows we are ignorant; inconsistent quality; lack of internal coordination. quality; lack of internal coordination. Information leaks to competitors.Information leaks to competitors.

Products involved are usually generic.Products involved are usually generic.

Methods of Obtaining Methods of Obtaining InputsInputs

2. Contracts—2. Contracts—Legally based extended relationship Legally based extended relationship between buyer and seller.between buyer and seller.

Benefits: Specialization; ability to Benefits: Specialization; ability to terminate sellers who do not perform; terminate sellers who do not perform; reduction in exploitation compared to reduction in exploitation compared to spot markets. spot markets.

Problems: Costly in complex Problems: Costly in complex environments; difficult to specify quality environments; difficult to specify quality exactly and to measure quality; exactly and to measure quality; unforeseen problems including liability unforeseen problems including liability issues.issues.

Contracting ComplexityContracting Complexity

Ford used annual bidding competition Ford used annual bidding competition to achieve low cost suppliers for auto to achieve low cost suppliers for auto parts ($7 billion a year). parts ($7 billion a year).

Problems: high administrative cost, Problems: high administrative cost, bankruptcy by suppliers (Delphi), bankruptcy by suppliers (Delphi), quality control unevenquality control uneven

Solution: multi-year contracts with Solution: multi-year contracts with fewer suppliers (down from 2,500 to fewer suppliers (down from 2,500 to 1,000); closer working relationship; 1,000); closer working relationship; estimated savings of 10% per year.estimated savings of 10% per year.

Many Forms of ContractsMany Forms of Contracts

Services Services (Deere and Ryder Trucks; (Deere and Ryder Trucks; UPS and Toshiba warranty laptop UPS and Toshiba warranty laptop repairs; UPS and Jockey; Japanese call repairs; UPS and Jockey; Japanese call centers in Dalien)centers in Dalien)

Joint Ventures Joint Ventures (foreign firms in China)(foreign firms in China) Leases Leases (office buildings)(office buildings) Franchises Franchises (McDonalds, car dealers)(McDonalds, car dealers) Strategic Alliances Strategic Alliances (Merck & Astra)(Merck & Astra)

Politics May Help Force Politics May Help Force FormForm

McDonalds in Japan was run by politically McDonalds in Japan was run by politically well-connected Japanese company (JMcD).well-connected Japanese company (JMcD).

Toys “R” Us (Toys) wanted to enter Japan but Toys “R” Us (Toys) wanted to enter Japan but bureaucrats stopped it.bureaucrats stopped it.

Alliance between JMcD and Toys: took care of Alliance between JMcD and Toys: took care of politics and found natural benefits—JMcD politics and found natural benefits—JMcD knew the Japan real estate and customer knew the Japan real estate and customer market well. Every Toys store had JMcD in market well. Every Toys store had JMcD in it. JMcD as profit partner had strong it. JMcD as profit partner had strong incentive to help Toys be successful.incentive to help Toys be successful.

Methods of Obtaining Methods of Obtaining InputsInputs

3. Vertical Integration—3. Vertical Integration—

(Non-market relations)(Non-market relations)

When a firm chooses to produce an input When a firm chooses to produce an input internally rather than contract with internally rather than contract with outsiders.outsiders.

Benefits: Reduced opportunistic behavior by Benefits: Reduced opportunistic behavior by outsiders and fewer contracting costs. outsiders and fewer contracting costs.

Problems: Lost specialization, locked into Problems: Lost specialization, locked into certain method of production, and increased certain method of production, and increased organizational (managerial) costs.organizational (managerial) costs.

Inputs are usually highly specialized.Inputs are usually highly specialized.

When Is Vertical Integration When Is Vertical Integration More Likely to Be More Likely to Be Necessary?Necessary?

To protect brand name. Examples: Sony, PradaTo protect brand name. Examples: Sony, Prada

When there are specific assets or high sunk When there are specific assets or high sunk costs. Examples: GM-Fisher Body.costs. Examples: GM-Fisher Body.

[Consider: Is it risky for an employee to [Consider: Is it risky for an employee to become asset specific to a particular become asset specific to a particular employer?]employer?]

When economies of scale changes—Coke and When economies of scale changes—Coke and Pepsi now own most bottling plants and Pepsi now own most bottling plants and control national marketing strategy.control national marketing strategy.

When coordination critical: stages of health When coordination critical: stages of health care.care.

What if you can’t trust What if you can’t trust “partners”?“partners”?

Chevron invests $ billions in oil field rights in Kazakhstan at north end of Caspian Sea. Then the question arose—how to get oil to market? Pipeline needed. Who must they deal with? Who has strongest hand? Who can wait longest?

Constant Change & Constant Change & LearningLearning Many firms opened “back offices” in India: Many firms opened “back offices” in India:

accounting; IT; customer service. Costs accounting; IT; customer service. Costs reduced about 45%. Cheap broadband price reduced about 45%. Cheap broadband price and large supply of quality workers in India and large supply of quality workers in India made this attractive.made this attractive.

But, by 2008, McKinsey and Nasscom But, by 2008, McKinsey and Nasscom reported that “captive” (vertical integrated) reported that “captive” (vertical integrated) back office costs were 30% higher than back office costs were 30% higher than same services provided on a contract basis. same services provided on a contract basis.

GE & Phillips both spun off back office GE & Phillips both spun off back office operations. Can’t always be done—such as operations. Can’t always be done—such as if security a major issue.if security a major issue.

Methods of Obtaining Methods of Obtaining InputsInputs

Summary:Summary:Are there specialized investments relative to Are there specialized investments relative to

contracting costs? If no—likely to use spot contracting costs? If no—likely to use spot market.market.

If yes—is the cost of contracting high relative If yes—is the cost of contracting high relative to the cost of integration? If yes—vertical to the cost of integration? If yes—vertical integration; if no—contracts with outside integration; if no—contracts with outside suppliers.suppliers.

Think about chickensThink about chickens

(or spinach).(or spinach).