Economic

 

On August 15, 2012, Google announced an agreement to acquire Motorola Mobility, based in Libertyville, Illinois, for $40 per share. Both boards of directors approved the deal (Google).

Describe why this was or was not a good economic decision for Google. Please incorporate what you have learned in Chapters 5 and 6 into your post. Defend your position.  

Reference:

Google. (n.d.). Facts about Google’s acquisition of Motorola. Retrieved from https://www.google.com/press/motorola/

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Title: The Organization of the Firm

Contents
Introduction …………………………………………………………………………………………………………………3

Check Your Understanding ……………………………………………………………………………………………3

Question 1 …………………………………………………………………………………………………………………………. 3

Question 2 …………………………………………………………………………………………………………………………. 3

Methods of Procuring Inputs ………………………………………………………………………………………….3

Spot Exchanges …………………………………………………………………………………………………………………. 3

Contracts …………………………………………………………………………………………………………………………… 4

Vertical Integration ………………………………………………………………………………………………………………. 4

Question 3 …………………………………………………………………………………………………………………………. 4

Question 4 …………………………………………………………………………………………………………………………. 4

Transaction Costs ………………………………………………………………………………………………………..5

Types of Specialized Investments …………………………………………………………………………………..5

Site Specificity ……………………………………………………………………………………………………………………. 5

Physical Asset Specificity……………………………………………………………………………………………………… 5

Human Capital ……………………………………………………………………………………………………………………. 5

Dedicated Assets ………………………………………………………………………………………………………………… 5

Implications of Specialized Investments …………………………………………………………………………..6

Costly Bargaining ……………………………………………………………………………………………………………….. 6

Underinvestment ………………………………………………………………………………………………………………… 6

Opportunism ………………………………………………………………………………………………………………………. 6

Check Your Understanding ……………………………………………………………………………………………6

Question 5 …………………………………………………………………………………………………………………………. 6

Question 6 …………………………………………………………………………………………………………………………. 6

Optimal Input Procurement ……………………………………………………………………………………………7

Spot Exchanges …………………………………………………………………………………………………………………. 7

Contracts …………………………………………………………………………………………………………………………… 7

Vertical Integration ………………………………………………………………………………………………………………. 7

Check Your Understanding ……………………………………………………………………………………………7

Question 7 …………………………………………………………………………………………………………………………. 7

Question 8 …………………………………………………………………………………………………………………………. 8

Economic Trade-off ………………………………………………………………………………………………………8

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Check Your Understanding ……………………………………………………………………………………………8

Question 9 …………………………………………………………………………………………………………………………. 8

Question 10 ……………………………………………………………………………………………………………………….. 8

Managerial Compensation …………………………………………………………………………………………….9

Incentive Contracts ……………………………………………………………………………………………………………… 9

External Incentives ……………………………………………………………………………………………………………… 9

Manager-Worker Principal-Agent Problem ……………………………………………………………………….9

Profit Sharing ……………………………………………………………………………………………………………………… 9

Revenue Sharing ………………………………………………………………………………………………………………… 9

Piece costs ………………………………………………………………………………………………………………………… 9

Check Your Understanding ………………………………………………………………………………………….10

Question 11 ……………………………………………………………………………………………………………………… 10

Question 12 ……………………………………………………………………………………………………………………… 10

Concept Scenario ………………………………………………………………………………………………………10

Scenario 1 ……………………………………………………………………………………………………………………….. 10

Scenario 1 Solution ……………………………………………………………………………………………………………. 11

Scenario 2 ……………………………………………………………………………………………………………………….. 11

Scenario 2 Solution ……………………………………………………………………………………………………………. 11

Scenario 3 ……………………………………………………………………………………………………………………….. 11

Scenario 3 Solution ……………………………………………………………………………………………………………. 12

Summary ………………………………………………………………………………………………………………….12

Review Questions ………………………………………………………………………………………………………12

Question 1 ……………………………………………………………………………………………………………………….. 12

Question 2 ……………………………………………………………………………………………………………………….. 13

Question 3 ……………………………………………………………………………………………………………………….. 13

Question 4 ……………………………………………………………………………………………………………………….. 13

What’s Next ………………………………………………………………………………………………………………13

Reference …………………………………………………………………………………………………………………13

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Introduction
Recall that the cost function defines the cost of producing given levels of outputs assuming all
inputs are used efficiently.

In this chapter, we consider techniques a firm can use to ensure that it is operating on the cost
function and not above it. We begin by discussing three methods managers can use to obtain
inputs needed in production: spot exchange, contracts, and vertical integration. For a firm to
minimize costs, it must use the least-cost method of obtaining the inputs.

The manager’s job is to choose the method that minimizes costs. Before we examine how to
determine the best method of acquiring a given type of input, it is useful to get a broad overview
of these three methods of acquiring inputs.

Check Your Understanding
Question 1
Is the following statement true or false?

How a firm obtains inputs can influence profit levels.

Answer

The statement “how a firm obtains inputs can influence profit levels” is true.

Question 2
Which of the following methods is not commonly used to obtain inputs in a cost-effective
manner.

• Vertical integration

• Contracts

• Spot exchange

• Cost backstopping

Answer

The cost backstopping method is not commonly used to obtain inputs in a cost-effective
manner.

Methods of Procuring Inputs
A manager can use several approaches to obtain the inputs needed to produce a final product.
Before we examine how to determine the best method of acquiring a given type of input, it is
useful to have a broad overview of these methods.

Spot Exchanges
When inputs are standardized, spot exchanges are commonly used to exchange inputs. Spot
exchange occurs when the buyer and seller of an input meet, exchange, and then go their
separate ways. With the spot exchange, buyers and sellers essentially are “anonymous”; the
parties may make an exchange without even knowing each other’s names, and there is no
formal (legal) relationship between a buyer and a seller.

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A key advantage of acquiring inputs with spot exchange is that it allows the firm to specialize in
what it does best—converting the inputs into output—and the input manufacturer specializes in
what it does best—producing inputs.

Contracts
A contract is a legal document that creates an extended relationship between a buyer and seller
of an input. It specifies the terms under which they agree to exchange over a given time
framework.

Contracts protect producers and make facets of purchasing decisions, such as price and
quantity of acquired inputs, predictable. Therefore, they offer greater flexibility for purchase non-
standardized inputs.

This method of obtaining inputs works well when it is relatively easy to write a contract that
describes the characteristics of the inputs needed. One key disadvantage of contracts is that
they are costly to write; it takes time, and there are often legal fees for writing a contract that
specifies precisely the obligations of both parties.

Also, it can be extremely difficult to cover all the contingencies that can occur in the future.
Thus, in complex contracting environments, contracts will necessarily be incomplete.

Vertical Integration
Vertical integration occurs when a firm produces the required inputs for its final product.
However, a firm loses the specialization it would have gained had the inputs been purchased
from an independent supplier.

Moreover, the firm now has to manage the production of inputs as well as the production of the
final product produced with those inputs. This leads to higher costs associated with a larger
organization. On the other hand, by self-producing the inputs it needs, the firm no longer needs
to rely on gathering inputs from external sources via spot exchanges or contracts. Check Your
Understanding

Question 3
Which of the following methods of acquiring inputs involves a firm producing its inputs
internally?

• Cost complementarity

• Vertical integration

• Contractual agreements

• None of the above

Answer

Vertical integration is the method of acquiring inputs that are produced by the firm internally.

Question 4
When inputs are non-standardized, which of the following is the most suitable method of
procuring inputs?

• Cost complementarity
• Vertical integration

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• Contractual agreements
• None of the above
Answer

Contractual agreements method is the most suitable method of procuring inputs when inputs
are non-standardized.

Transaction Costs
Costs associated with acquiring an input that exceed the amount paid to the input supplier are
called transaction costs.

Transaction costs arise when a manager incurs expenditures in the process of facilitating an
exchange which include searching for a supplier willing to sell a given input and negotiating the
price for purchasing the input.

Types of Specialized Investments
Transaction costs could be specific to a particular trading relationship or they can be of a
general nature.

Some transaction costs arise due to the specific nature of the transaction. Such transaction
costs need to be incurred, otherwise the transaction will not occur and cannot be recovered in
another trading relationship. Transactions of this type are called specialized investments. Due
to the specialized nature of these transactions, the resulting relationship between the parties is
known as a relationship-specific exchange. As a result of the uniqueness of the needs of both
parties, the two parties are tied together.

Site Specificity
Site specificity occurs when the buyer and the seller of an input must locate their plants close to
each other to be able to engage in exchange. For example, a biofuel plant that is located close
to corn farmers.

Physical Asset Specificity
Physical asset specificity refers to a situation where the capital equipment needed to produce
an input is designed to meet the needs of a particular buyer and cannot be readily adapted to
produce inputs needed by other buyers. For example, drill bits for drilling in unique geographical
positions.

Human Capital
Human capital refers to a situation where workers occasionally pick up specialized skillsets that
may not be easily transferable to other employers. In such cases, they represent a specialized
investment. For example, a kicker for NFL team may not find his particular talent for kicking field
goals transferable outside the game of football.

Dedicated Assets
Dedicated assets are general investments made by a firm that allows it to exchange with a
particular buyer. For example, a firm’s investment in technology that enables it to produce
fighter jets according to U.S. military specification; aside from the US military, that firm would not
be able to sell those jets to any other buyer.

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Implications of Specialized Investments
Now that you have a broad understanding of specialized investments and relationship-specific
exchange, we will consider how the presence of specialized investments increases transaction
costs of acquiring inputs.

Costly Bargaining
Specialized investments imply that only a few parties are prepared for a trading relationship.

Consequently, there is no “market price” for the input the two parties in the relationship-specific
exchange bargain with each other over a price the input will be bought and sold under. The
bargaining process is costly because each side employs negotiators to obtain a more favorable
price.

Underinvestment
Due to the specific features of the transaction, the level of specialized investment often is lower
than the optimal level. For example, if an input supplier must invest in a specific machine to
produce an input used by a particular buyer (physical-asset specificity) the supplier may invest
in a cheaper machine that produces an input of inferior quality. This is because the supplier
recognizes that the machine will not be useful if the buyer decides to purchase from another
firm, in which case the supplier will be “stuck” with an expensive machine it cannot use. Thus,
specialized investments may be lower than optimal, resulting in higher transaction costs
because the input produced is of inferior quality.

Opportunism
A strategy especially used in price negotiations, is when a supplier of specialized inputs knows
they can delay production of a firm that needs that unique input by not supplying it on time,
known as the ‘hold-up’ problem. It is opportunistic for the supplier of an input to take advantage
of the need for his services. The buyer of the input can also engage in opportunistic behavior
knowing that the input supplier would have a hard time selling their product elsewhere. In both
cases, transaction costs increase. However, contracts can be structured to mitigate the hold-up
problem.

Check Your Understanding
Question 5
Which of the following is not a transaction cost?

• Taking time to search the internet for a suitable supplier

• The cost of exchanging currency in order to pay for an imported input

• The cost of delivering a product to a consumer

• Energy costs incurred in production process

Answer

Energy costs incurred in production process is not a transaction cost.

Question 6
Which of the following types of specified investment relates to an individual the most?

• Dedicated assets

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• Human capital

• Physical asset specificity

• Site specificity

Answer

Human capital investment relates to an individual the most.

Optimal Input Procurement
Let’s now examine, how the manager should acquire inputs in such a way as to minimize costs.
The cost-minimizing method will depend on the extent to which there is relationship-specific
exchange.

Spot Exchanges
Spot exchange is the most straightforward way for a firm to obtain inputs for a production
process. We can determine the market price (p*) of an input by the intersection of the supply
and demand curves for the input if there are no transaction costs and there are many buyers
and sellers in the market. Given that the inputs are typically standardized, a manager can easily
obtain the input from a supplier,chosen at random, by paying a price of p* per unit of input. If
any supplier attempted to charge a price greater than p*, the manager could simply decline and
purchase the input from another supplier at the same price.

Contracts
To mitigate the hold-up problem, parties can enter into an appropriately structured contract that
reduces the incentive for either party to engage in any hold-up behavior. This is done by
specifying prices of the input that are acceptable to both parties and that will be honored for a
certain time period prior to either parties making specialized investment expenditures.

Vertical Integration
Complete contracts have their drawbacks. They may not be able to address all features of a
complex transaction or cover all price risks that come from general economic conditions. In
these conditions, the best choice for the firm is to set up a facility to produce the input internally.
Vertical integration is a more suitable choice since it entails that the firm move further up the
production stream toward increasingly basic inputs.

The advantage of vertical integration is that the firm “skips the middleman” by producing its own
inputs. However, vertical integration can be expensive and time-consuming. It also distracts the
firm from its core business and leads it further away from concentrating on what it does best.

Check Your Understanding
Question 7
Is the following statement true or false?

Contract price is determined by market forces of supply and demand.

Answer

The statement is false. Contract price is not determined by market forces of supply and
demand.

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Question 8
Which of the following is true?

• Vertical integration is a strategy best suited when a company need standardized
products.

• Price agreements are an important part of contractual agreements.

• Suppliers of input cannot overprice in spot exchanges.

• Spot exchanges are the easiest path of input procurement.

Answer

The true statement is: Suppliers of input cannot overprice in spot exchanges.

Economic Trade-off
The cost-minimizing method of acquiring an input depends on the characteristics of the input.
The input procurement of choice depends on the importance of the specialized investments that
lead to relationship-specific exchange.

When the desired input does not involve specialized investments, the firm can use spot
exchange.

When the desired input involves specialized investments, the next determination a manager
should make is balancing the cost of navigating the complexity of a contractual environment
against the costs of integration.

If the contractual environment is simple and the cost of writing a contract is less than the
transaction costs associated with spot exchange, it is optimal to acquire the input through a
contract. In this case, the optimal contract length is determined by the intersection of the
marginal cost and marginal benefits of writing a longer contract.

If the cost of navigating the complexity of writing a contract is greater than the cost of
integrating, the manager should integrate vertically to minimize the cost of acquiring inputs
needed for production.

Check Your Understanding
Question 9
Is the following statement true or false?

Standardized input markets typically create complex contracting environments.

Answer

The statement is false. Standardized input markets typically do not create complex contracting
environments.

Question 10
Which of the following would dissuade a manager from pursuing vertical integration the most?

• A firm’s financial resources

• Price risks

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• Complex contract environments

• The hold-up problem

Answer

A firm’s financial resources would dissuade a manager the most from pursuing vertical
integration.

Managerial Compensation
One characteristic of many large firms is the separation of ownership and control. The owners of
the firm are often distantly located stockholders, and a manager runs the firm on a day-to-day
basis. The fact that the firm’s owners are not physically present to monitor the manager, creates
a fundamental incentive problem, termed as the “principal–agent” problem. If the owner is not
present to monitor the manager, how can they get the manager to do what is in their best
interest? Strategies for disciplining managers include incentive contracts and external
incentives.

Incentive Contracts
Incentive contracts are rewards for managers typically based on performance. Such rewards
benefit stockholders as well as C E Os. Reducing performance-based rewards may result in a
decline in profit for the firm.

External Incentives
Forces outside the firm often provide managers with an incentive to maximize profits; such as:

1. Reputation: A manager’s incentive for their high performance is to increase their
chances of getting future job opportunities outside a firm.

2. Takeovers: Threats like investor-driven takeovers that replace a firm’s management
could drive managers to perform well.

Manager-Worker Principal-Agent Problem
An important question arises in manager-worker relationships: How can a manager (or a
principal) induce workers (or agents) to perform at their best? This question is central to the
manager-worker or principal-agent problem.

Possible solutions to manager-worker or principal-agent problems include profit sharing,
revenue sharing, and piece costs.

Profit Sharing
Profit sharing involves offering workers compensation that is tied to the underlying profit. It
provides an incentive for workers to put more effort in their tasks.

Revenue Sharing
Revenue sharing involves compensating the workers’ based on the underlying revenues of the
firm such as tips and sales commissions. The drawback, however, is that they incentivize
workers to focus more on revenues and less on minimizing costs.

Piece costs
Piece-cost workers are compensated based on their rate of output, which means the
compensation is dependent on their production quantity. The drawback of this approach is that

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the quantity of output is incentivized without a necessary regard for the quality of the output.
Spot checks could be instituted to ensure that the quality of the work is satisfactory; while time
clocks could be put in place to check if workers are not shirking from work during business
hours.

Check Your Understanding
Question 11
The separation of ownership and control:

• Makes it harder to maximize share price

• Applies to all firms that are not sole proprietorships

• Creates a disconnect between what the workers want and what the owners want

• None of the above
Answer

The correct option is none of the above. The separation of ownership and control creates a
fundamental incentive problem.

Question 12
The best strategy to incentivize workers, when worker productivity is related to revenues rather
than cost, is:

Answer

Revenue sharing is the best strategy to incentivize workers when worker productivity is related
to revenues rather than cost.

Concept Scenario
Scenario 1
You work for an oil and gas company that has offshore drilling facilities. One of the essential
inputs in the extraction process is a gadget, made out of plastic, which ensures that oil is
extracted at a safe and optimal rate. Your company acquires this input from another firm that
manufactures it, using a derivative of petroleum. There are not many manufacturers who can
make this gadget. What options does your firm have to procure this input?

Tip 1

Peer 1: Spot exchanges would be a good option because they are easy to find.

Peer 2: Well it sounds like they produce the product that the input is made out of, so maybe they
could write a contract to get the input from the supplier at a particular price.

Tip 2

Watch the Horizontal and Vertical Integration video to find your solution.

Tip 3

Refer to the lecturette section on vertical integration to find your solution.

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Scenario 1 Solution
Since your firm is at risk for hold-up behavior from the small pool of suppliers who make the
input and produce the raw material (petroleum) that is used to make the input (the plastic
gadget), your firm should consider making the input in-house (vertical integration).

Scenario 2
Suppose you firm has decided to enter into negotiations regarding a potential contractual
agreement with a supplier of an input. One of last remaining issues to agree on is the duration
of contract. You have been tasked by upper management to figure out what the optimal contract
duration should be. What information would you ask for to determine the duration?

Tip 1

Peer 1: Perhaps you should ask the production department how long your firm would take for
the input to be made by your company and use that as a timetable.

Peer 2: It is better to consider the cost of looking for another supplier and use that as a
benchmark for the contract duration.

Tip 2

Watch the instructional video, Scarcity, Opportunity Cost, Trade-Offs & The Production
Possibilities Curve, to find your solution.

Tip 3

Refer to the Lecturette section on the Economic Trade-off to find your solution.

Scenario 2 Solution
You would need to calculate the marginal costs and benefits of a longer contract –where they
intersect would mark the optimal contract duration.

Scenario 3
Suppose you are a manager who owns a transportation logistics company. Your company has
been contracted to haul loads of merchandise. For each delivery, time is of the essence –the
firm is given a bonus for early deliveries and is charged a penalty for late deliveries. You are
trying to think of a compensation system for your workers and/or drivers. Your incentive is to get
the load delivered as fast as possible. Therefore, the best outcome for you is for your drivers to
be taking the shortest trip per load. The best outcome for your drivers is a large wage at the end
of their day. What kind of compensation system would provide your drivers with incentives to
find the quickest route per load?

Tip 1

Peer 1: I think you should pay them according to the distance they travel.

Peer 2: I think you should tell your drivers how important it is to get the merchandise delivered
as fast as possible.

Tip 2

Watch the video The Principal Agent Problem, to find your solution.

Tip 3

Refer to Lecturette section on the Manager-Worker Principal-Agent to find your solution.

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Scenario 3 Solution
Since delivery time influences revenues, you can consider tying driver compensation to
revenues generated per trip. Therefore, if there is a penalty imposed on the firm for late
deliveries, the driver also experiences a reduction in income. The driver has an incentive to take
the route that ensures on time delivery. Further, since they could receive a larger wage if they
deliver the merchandise early, the incentive for the shortest route is more pronounced.

Summary
Key learning points in this module include:

• Three methods managers can use to obtain inputs needed in production: spot exchange,
contracts, and vertical integration.

• Spot exchange occurs when the buyer and seller of an input meet, exchange, and
then go their separate ways.

• A contract is a legal document that creates an extended relationship between a
particular buyer and seller of an input.

• Vertical integration occurs when a firm produces the inputs required to make its final
product.

• Costs associated with acquiring an input that exceed the amount paid to the input
supplier are called transaction costs.

• There are different types of specialized investments, namely: site specificity, physical
asset specificity, human capital, and dedicated assets.

• Specialized investments increase transaction costs because they lead to costly
bargaining, underinvestment, and opportunism.

• The input procurement of choice depends on the importance of the specialized
investments that lead to relationship-specific exchange.

• The inability of a firm’s owners to monitor the manager creates the principal-agent
problem.

• Strategies to mitigate the owner-manager principal-agent problem include: incentive
contracts and external incentives.

• The challenge of monitoring workers to prevent shirking from work creates the manager-
worker principal-agent problem.

• Possible solutions to the manager-worker principal-agent problem include: profit sharing,
revenue sharing, and piece rates.

Review Questions
Question 1
When inputs are standardized, which of the following is the most suitable method of procuring
those inputs?

Answer

When inputs are standardized, spot exchanges are most suitable for procuring those inputs.

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Question 2
If an input is non-standardized and the contractual environment is simple, what method of input
procurement is the most appropriate?

Answer

If an input is non-standardized and the contractual environment is simple, the contracts method
of input procurement is the most appropriate.

Question 3
Under what conditions would vertical integration be an appropriate method of input
procurement?

Answer

When substantial specialized investments are required and the desired input has complex
characteristics that are difficult to specify in a contract, or when it is very costly to write into the
contract all the clauses needed to protect the parties from changes in future conditions, the
manager should integrate vertically.

Question 4
Describe the difference between the owner-manager principal-agent problem and the manager-
worker principal-agent problem.

Answer

The owner-manager principal-agent problem asks the question: How can the owner (the
principal) induce the manager (the agents) to perform in their interests to the best of their
ability? Whereas, the manager-worker principal-agent problem asks the question: How can the
manager (the principal) induce the workers (the agents) to perform at their best?

What’s Next
In Module 6, we will cover Chapter 7, which shows that different industries have different market
structures and require different types of managerial decisions. We will explore how firms in the
industry, the structure of demand and costs, the availability of information, and the behavior of
other firms in the industry affect managerial decision making. We will examine different
approaches to measure market concentration and how they provide managers with information
about industry cost and demand conditions.

We will close the chapter by revealing industry-wide differences in activities such as advertising,
research, and development.

Reference
Baye, M. R., & Prince, J. T. (2013). Managerial economics and business strategy (8th edition).
New York, NY: McGraw-Hill Education.