Organization of Firm

Learning Objectives:

• How do firms hire inputs of production?

• What are transaction costs?

• What is the Principal-Agent problem?

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

Transaction Costs

• Transaction Costs are the excess costs incurred for acquiring inputs other than the prices of inputs.

• Two types: • Search cost • Matching cost

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

Specialized Investments and Transaction Costs

• Costly Bargaining

• Underinvestment

• Opportunism

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

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