Download Economics of Management Strategy BEE3027

Economics of Management Strategy
BEE3027
Miguel Fonseca
Lecture 1
Some background
• Where can you find the relevant course material
for this half of the course?
• http://people.ex.ac.uk/maf206/ems.htm
• Most lectures will have an accompanying
problem set and reading list.
• We will use the second hour to answer and
discuss problem sets from previous weeks.
Some background
• Problem sets will give you a flavour of what to
expect in the exam.
• They will mainly be problem solving questions
although I may include some essay questions.
• If you have any questions outside class, my
office hours are:
–13:30 to 15:30 on Mondays
A roadmap for this half of the course
• In this half of the course, we shall look at how
economists think about the firm:
– Why does it exist?
– How is it organised?
– What kind of incentive structures can be in place for
employees?
– What is the economics behind the pricing and
marketing strategies available to firms?
– How do firms evaluate projects?
– What are the issues regarding a firm’s corporate
control and financial structure?
Neoclassical theory of the firm
• Traditionally economists look at the firm as a
black box.
• For a given set of inputs, it produces a set of
outputs.
• No explanation is given for why it exists and
what limits there are for firms, either in scale or
in scope.
Cost concepts
• Opportunity cost
– Value of the factor in its next best alternative use
• Economic costs of durable inputs
– e.g. Depreciation
• Avoidable costs vs. sunk expenditures
• Short run vs. long run
– In SR, some inputs are fixed (e.g. building)
– In LR, all inputs are variable → all costs avoidable;
• Variable and fixed costs
Economies of scale
• Economies of scale refer to the relationship
between a firm’s output and cost function:
– They occur when the long-run average cost
declines as output rises.
• They exist due to indivisibilities.
– (Long-Run) Fixed Costs;
– Setup costs;
– Specialised resources;
– Volumetric returns to scale/economies of massed
reserves;
Economies of scale
Economies of scope
• Another advantage of being large is that one is able to
produce more than one good based on a given set of
(common) inputs.
• If two different goods require similar production
technology (e.g. cars and trucks), a firm may take
advantage of a large production facility.
• Formally, in the two good case, economies of scope
exist if:
C(q1, q2) < C(q1, 0) + C(0, q2)
Why do firms exist?
• So far, neo-classical economics tells us nothing
about why firms exist.
• Coase (1937) was the first economist to pose
this question.
– He argues that the defining feature of the firm is that
production is organised by command.
– If market exchange is efficient, why aren’t all firm
activities outsourced to market agents?
What is the optimal firm size?
• Coase also wondered what determines firm
size.
• His argument was:
– if firms exist, there must be an advantage to
produce under such structures!
– Therefore, why not organise production by one very
large firm?
Transactions cost
• The key to answering both questions lies in
transaction costs.
• Although economic theory assumes (in the vein
of Physics) that real-world markets are
frictionless, there are a number of issues that
permeate transactions.
• Hence, firms will choose the modus operandi
which minimise these transaction costs.
Alternative Economic Organisations
•
Before elaborating on the notion of transaction
costs, let us consider three basic forms of
organising production processes:
1. Spot markets;
2. Long-term contracts;
3. Vertical integration.
Dimensions of Transactions
• Asset Specificity
• Frequency and Duration
• Complexity and Uncertainty
• Difficulty of Performance Measurement
• Connectedness to other Transactions
Asset specificity
• In most business relationships, both supplier and firm
make specific investments to maximise profits (e.g.
building a production line).
• The degree of asset specificity is a function of its
alternative uses, what economists call Quasi-Rents.
• Quasi-Rent = value of asset in its current use – value
of asset in its next-best use.
• The more specific the asset, the lower the value in its
next-best alternative use, and the higher its quasi-rent
will be.
Asset specificity
•
Physical-Asset specificity
•
Site specificity
•
Human-Asset specificity
•
Dedicated Assets
Asset specificity
• The higher the degree of asset specificity, the
more attractive in-house production will be visà-vis outsourcing.
• One of the main reasons for this is what
economics calls the ‘hold-up problem’.
Hold-up problem
• Relationship-specific investments also change
the relationship between supplier and buyer.
• Once these investments are made by one of
the parties, there is scope for opportunistic
behaviour by the other party.
• That is, the other party has an incentive to renegotiate the contract, and extract some or all
of the other firm’s quasi-rents.
Hold-up problem: example
• Consider the case of a soft drink company.
• Cost of bottles: Cb = TVB + F, where
– TVB is the total variable cost of making bottles
– F is the Fixed cost of the machines needed.
• If bottle making market is perfectly competitive,
the winning bid for a contract would specify a
price = Avg cost => 0 profits for bottle maker.
Hold-up problem: example
• Assume:
– R is revenue from water sales;
– TVP is variable cost of producing soft drinks;
– S is the salvage value from re-selling bottle making
machinery.
Hold-up problem: example
• Gains from trade between two firms are:
– V = R – TVP – TVB
• If firms decide to part ways, they must look for
alternative trading partners.
– Bottle maker could sell machinery for S. Its quasirents are F – S.
– The water company must spend F and T to search
for new supplier. Its profit would be V – F – T. Its
quasi-rent would be (V – F) – (V – F – T) = T.
Hold-up problem: example
• The outside option would be to terminate
relationship, yielding the following surplus:
– O = (V – F – T) + S
• They will continue relationship as long as it is
more profitable than switching, i.e. if V – O > 0.
– V – O = V – ((V – F – T) + S) = F – S + T
• F – S is the amount accrued to the supplier
• T is the amount accrued to the firm.
Hold-up problem: example
• If F – S + T > 0, there is a financial basis for a
long-term relationship.
• Terminating the relationship yields losses equal
to the quasi-rents.
• However, once the agreement is signed, both
parties have an incentive to renegotiate!
Hold-up problem: example
• The firm can claim “production costs have
risen” and offer to pay S + £0.01 + TVB instead
of F + TVB.
• If supplier rejects offer, it can recoup S. If it
accepts, it receives S+£0.01.
• Alternatively, the supplier can also try to
renegotiate by requiring F + T - £0.01 + TVB, as
opposed to original F + TVB.
Hold-up problem
• As shown in the example, both sides to the
transaction may have an incentive to
renegotiate the terms of the contract.
• When successful, this results in the
redistribution of the quasi-rents inherent to the
transaction.
• The more asset-specific the investment by both
parties, the more likely this is to happen.
Contracts
• We have just seen what are the circumstances
under which people may be reluctant to acquire
production inputs through spot markets.
• An obvious solution to the previous example
would be for the two parties to write down a
contract where they specify the price to be paid.
• So why not use contracts exclusively?
Complete vs. Incomplete Contracts
• Complete contract:
– A contract which perfectly specifies a distribution of
the gains of trade for every possible contingency
and which is perfectly enforceable, without need of
revision.
• Most contracts must be negotiated, updating
and enforced.
• The costs associated with such activities are
called transaction costs.
Transaction Costs
• Even if a complete contract were to be drawn
up, it would still imply transaction costs:
– Figuring out all possible contingencies;
– Reaching an agreement on for each of the above;
– Writing the contract in acceptable terms;
– Monitoring costs;
– Enforcement costs (e.g. lawyer fees).
• This means real-world contracts are incomplete
Transaction Costs
• The more complex the transaction, the higher
the costs of drawing up a contract.
• The possibility of hold-up also makes firms
allocate resources to non-productive activities,
which yield inefficiencies:
– Writing and renegotiating complex contracts;
– Monitoring and preventing hold up
• Making investments to prevent being locked in to one
supplier;
– Underinvestment in specific assets.
Transaction Costs
• Of course, contracts can also be a source of
hold up!
• If firms are tied in long-term contracts, if
economic conditions change, the party who is
better off has no incentive to renegotiate.
• So, the other alternative for production is to
vertically integrate the production chain.