Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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.