1 ECONOMICS 3200B Lecture 3 Ch. 2 September 24, 2013.
-
Upload
dorthy-osborne -
Category
Documents
-
view
215 -
download
0
Transcript of 1 ECONOMICS 3200B Lecture 3 Ch. 2 September 24, 2013.
1
ECONOMICS 3200BLecture 3
Ch. 2
September 24, 2013
2
Existence of Firms
Options
• Markets and firms alternative means for completing related sets of transactions
• Short-term contracts – costs, uncertainty re. supply
• Long-term contracts – opportunistic behavior
• Ownership/control – internalization
3
Existence of Firms
Transactions costs:
• Costs in using markets– Search costs – suppliers, prices
– Negotiating, writing, monitoring and enforcing contracts
• Classical firm as nexus of contracts – hub/spoke
• Duration of contracts and increasing complexity– Uncertainty re. future states
– Increasing number of contingencies – increasing complexity
– Incomplete contracts – trade-offs between more complex contracts/higher costs and simpler, incomplete contracts
– Opportunistic behavior – incentives to breach contracts
• Proprietary rights to information – investment ideas, market demands, product design, service innovations, etc.– Value depends on package of rights and other factors – cannot contract for
all factors
4
Existence of Firms
• Internalization (insourcing)– avoid using marketplace by ownership of inputs, expansion of value-added activities conducted within firm– Bargaining power vis a vis market – credible threat to shift
production
– Inefficiencies as firm becomes larger• Control problems associated with bounded rationality (limits to
information any person can absorb and massage); weak incentives (difficulty in measuring direct contributions of individuals or divisions to overall financial performance of company); distortion as information (decisions) pass through more levels within organization
5
Existence of Firms
Internalization• Vertical integration, horizontal diversification
• Reduce transactions costs
• Economies of scale, scope
• Transferability of source of competitive advantage (design, marketing, costs, superior management, reputation)
• Proprietary information
• Tax advantages – transfer pricing
• Quality control – minimize liability risks; Boeing and 787
• Entry deterrence – BCE, Rogers and MLSE; BCE and Astral; Airlines
and slots • Circumvent rate of return regulations
6
Existence of Firms
Disadvantages of Internalization• Diseconomies of scale – outsourcing
• Internal transfer prices and corporate politics
• 3rd party opportunities for internal divisions – economies of scale, creating opportunity for competition
7
Existence of Firms
• Advantages of engaging in market transactions – outsourcing (near-sourcing) a new term for an old idea, namely, using the market to acquire inputs or sell outputs– Specialization/focus for firm
– Market prices serve as reference points for internal transfer pricing
– Economies of scale – ability to serve 3rd party customers
– Link between performance/rewards
8
Existence of Firms
Optimal size of firm• MC of internalizing vs. MC of external transactions
• Diseconomies of scale vs. economies of scale/scope
• Technological change (communications, transportation, organization)
• Optimal size differs across industries, time, location (country-specific characteristics)
• Costs – e.g. transportation costs; reputation
• Optimal size different question than why do firms grow
9
Typology of Costs
Variable costs, fixed costs• Time dimension• Fixed costs
– Independent of output– May be fully or partially recoverable if firm exits
• Variable costs– Vary with rate of production
• Demand variability and ratio of fixed to variable costs– Cyclical industries
10
Typology of Costs
Fixed costs, sunk costs• Distinction between sunk and fixed costs: no market
value; no retrieval/scrap value
• Sunk costs– Not recoverable if firm exits or fails– Specialized equipment with zero scrap value – no alternative
uses– Specialized investment: wastewater treatment plant; specialized
dies/molds; advertising campaign; advisory fees (investment banking services for raising capital or acquisition/divestiture)
– Ex post, sunk costs do not impact pricing or other strategic decisions
– By-gones are by-gones – historical costs not important for decision-making; what matters are actual current market values
11
Typology of Costs
• Ex ante vs. ex post costs of investment – prior to making an investment, must consider the size of the investment (the actual current cost of physical capital to be acquired or the R&D or marketing budget); following approval of the investment, only the opportunity cost of the actual current market value of the investment matters in the decision-making process
• Pricing of hotel rooms, seats on planes, rental cars, cloud computing – inventory committed so fixed costs become sunk costs if inventory not used/sold (investment in an empty hotel room or an empty seat on a flight or server capacity is not recoverable)
12
Typology of Costs
Opportunity costs– Consider in decision-making re. investment strategies– Investing in new equipment: cost of capital –
opportunity cost of capital, e.g. equity• Cost of equity: expected return on next best investment
opportunity with comparable risk profile, i.e. bankruptcy risk
• Equity a higher cost source of capital than debt even though there are no fixed interest payments
13
Typology of Costs
Opportunity costs
– Fully depreciated real estate, capital equipment: opportunity cost is return on selling these assets and investing the market price proceeds; even if fully depreciated, market value of assets should be factored into investment/strategic decisions of company
– Non-performing loans – market for non-performing loans priced at discount to face value
• Non-performing loans should be written down to prevailing market price – loans generally marked to market
14
Typology of Costs
Marginal, average variable, average fixed and average total costs
– Marginal costs: change in total costs (variable costs) resulting from increased production/distribution of one unit
– Average variable costs: total variable costs divided by total number of units produced
– Average fixed costs: total fixed costs divided by total number of units produced
– Average total costs: sum of average variable costs and average fixed costs
• Shut-down point – if negative cash flows with AVC < P < ATC, will creditors provide additional financing?
15
Cost Minimization
• Value-added chain scope for company• What should a company do?
– Core competencies, basis for competitive advantage critical as is organization structure, diseconomies of scale and importance of control over proprietary information or distribution
• Boundaries for a firm: what should it buy in marketplace, where should it come in contact with marketplace, internalizing vs. outsourcing?
16
Costs
• Determinants of total costs– Input prices; quantities of each input; value
chain activities; transportation costs; distribution costs
– Trade-offs between economies of scale and transportation costs
17
Costs
• Input prices– Location of the company
– Location of the sources of inputs– Exchange rates
• Hedging
– Transportation costs
– Tax and tariff rates
– Bargaining power
– Quality of the inputs
– External (outsourcing) vs. internal (insourcing) transactions
18
Costs
• Quantities of each input – Technology
– Organization structure – X inefficiency
– Economies of scale – external, internal
– Learning curves
– Quality of inputs
– Relative prices
– Production rates – peak load, smoothing and inventories, overtime
19
Cost Minimization
• Minimize costs – unit costs (average total costs), marginal costs, fixed costs, total costs
– Minimizing unit costs may require operating at or near capacity – optimal capacity level
– Different technologies for different levels of capacity – flexibility, different cost structures
– Economies/diseconomies of scale – level of demand– Economies of scope– Rate of production
• Time frame for minimizing costs – adjustment opportunities, competitive disadvantages for slow adjustment, behavior of competitors, adjustment costs
• Can any company afford not to focus on minimizing costs?
20
Cost Minimization
• Decisions facing companies:– Production technologies: flexibility for production,
substitutability among inputs, knowledge about alternative technologies, vintage of technologies, optimal level of capacity, skills to accommodate different technologies (training)
– Does company use different production technologies in different countries?
– Location: exchange rates and costs, tax rates, subsidies, input prices, transportation costs
– Organization structure – HR policies• Rate of expansion, pricing: first mover advantages
(economies of scale, learning curves); first mover disadvantages (selecting inferior technologies, wrong set of value chain activities)
– Investment in capacity in anticipation of increased sales volume, e.g. new production equipment imbedding latest technologies
21
Cost Minimization
• Inputs: labor, capital, other inputs, components, services– Availability, prices, trade-offs – some inputs available at lower
prices in some locations, while others available at lower prices in other locations (location decisions)
– Optimal combination of inputs depend upon relative prices, technologies, activities of company (where is the company located in the value-added chain, degree of vertical integration)
– Organization structure – mechanism for controlling production and other value added chain activities
• Outsourcing vs. insourcing
– Incentives to maximize effort, minimize waste and defects – hierarchical and control structure, internal rewards/penalties, reputation (invisible handshake/implicit contract)
22
Cost Minimization
• Human resources (cost cutting through layoffs and wage concessions)
– Labor costs and availability of skills – training costs, commitment to work, effort
– Productivity enhancing innovations recognized by employees• Loyalty and effort – work generates negative utility/welfare for
individuals (people work for the income that affords them the opportunities to buy desired goods/services)
– Incentives for encouraging loyalty and effort• Rewards (bonus, promotions, recognition)• Invisible handshake (commitment by employers to maintain
employment levels, offer training and upgrading of skills, and continually offer promotion opportunities)
• Golden handcuffs – job ladders and seniority, vesting in pensions, economic rents (above market compensation)
• Penalties (firing)• Job uncertainty, reneging on invisible handshake – impacts on
motivation, effort (longer-term cost implications)
23
Cost Minimization
• Location decision– Transportation costs – inputs, outputs– Labor costs, availability of labor skills– Costs and availability of variety of qualities of other inputs – Property taxes, business taxes– Personal taxes impact location decisions because executives
concerned with after-tax income – agency problem– Exchange rates – currency risks– Access to specialized resources – capital equipment
manufacturers, research facilities, subcontractors (including advertising, finance)
– Regulations: environment, health and safety, product liability, employment standards, etc.
– Legal system: rent seeking, bribes
24
Costs
• Minimum efficient scale – relation to size of market influences number of potential competitors
• Economies of scope
• C(Q10) + C(Q20) > C(Q10, Q20)– Cost advantages of producing more than one product (joint production)
rather than specialization in single product
– Complementarities in production, marketing, distribution, research
• Search and transactions costs – impact of Internet
25
Efficiency
• Production efficiency– Minimize costs of production
– With given state of technology (origins?) and factor prices, optimal combination of factors of production and optimal organization structure to minimize shirking
– X-inefficiency
– Agency problem and alignment of of interests – corporate jets vs. flying on commercial airlines
• Allocative efficiency– Optimal allocation of scarce resources among products produced in
economy
– Prices reflect social value of inputs at margin
– Pareto efficient allocation – unable to reallocate factors so as to improve one person’s welfare without reducing another’s
26
Efficiency
• Dynamic efficiency– Productivity growth and improvements in real standards of living
– Rate of innovation and rate of diffusion of innovation
– Lower production costs because of reduced resource use (higher productivity), higher quality products, new products more highly value by consumers
– Market structure required to maximize dynamic efficiency?