Organization of the Firm

1
Chapter 6

• Organization of the Firm

2
Organizing Transactions

• Labor services can be hired in many ways.
• Labor input must be motivated to perform to
  achieve firms objectives.
• Three types of transactions
• Spot exchange
• Contract
• Internal organization

3
Transaction Costs

• Most effective organization depends on TC
• Three sources of transaction costs
• Searching
• Negotiating
• Specialized investments

4
Spot Exchange

• One time trade and immediate exchange of service
• known service quality (commodity)
• verifiable delivery at payment
• Service must be easily found
• No search costs.
• Service provider bears no transaction-specific
  costs.
• May be repeated over time.

5
Spot Exchange, contd.

• Getting required quality of service does not
  require direction of sellers effort by the
  buyer.
• Prices are sufficient information.
• Price system economizes on time and attention.

6
Using Spot Transactions

• Manager of Pizza-Shack pays drivers to deliver
  pizzas.
• Pays fee per delivery.
• Are drivers easily found when needed?
• If paid ahead, can driver just take the pizza?
• If paid after, can manager stiff the driver?
• What if the driver has to buy a uniform and
  decals for the car?

7
Contracts

• Contract is required if service provider incurs
  transaction specific costs (uniform).
• Service provider retains control over how it
  meets requirements of contract (not closely
  monitored).
• Contract must specify quality and motivations
  (timeliness, distance).
• Enforcement is required (penalty for
  nonperformance, legal enforcement).
• Contracts require attention to write.

8
Using a Contract

• Manager writes contract specifying terms
  (delivery, payments, penalties).
• Penalties for nonperformance must be enforced by
  courts (small claims court).
• Costly to write a contract for each delivery.
• Who pays for uniform and decals?

9
Transaction Costs

• Required fixed costs in addition to price
  incurred to purchase or provide an product or
  service.
• Search, negotiate, investments.
• Must revenues to seller (price x quantity) cover
  production costs (VC) and transaction costs (FC)?

10
Specific investments

• Provider buys specialized equipment, commits to
  location, invests in human capital.
• Bargaining problems arise because there is a
  single buyer and seller.
• Once specific investments are made, they are sunk
  costs.
• This leads to opportunism renegotiation of
  terms hold-up problem.
• Seller may under-invest in specific assets.

11
Specific investments prevent spot exchange

• Seller cannot recoup cost of investment.
• Buyer will not make investment for seller.
• If these specific investments are high enough
  internalization is best
• Then the buyer makes the investment.

12
Internalize

• Purchaser acquires control over how service is
  provided.
• Services required are not explicitly specified in
  contract.
• Service provider accepts direction of efforts
  from buyer.
• Service is fitted to needs of buyer.
• Provider requires direction (attention) from
  buyer.

13
Hiring the Driver

• Manager pays for and controls drivers time
  (monthly salary).
• Time and distance for each delivery are not
  specified (driver is on standby).
• Driver makes whatever deliveries required by the
  manager.
• Manager still must spend time giving the driver
  instructions.

14
The Principal-agent Problem

• Employee motivation and compensation
• Example stockholders and management
• Performance of stock depends on managers effort
  and other factors.
• Managers effort is costly to manager.
• Owner cannot perfectly monitor manager.

15
Piece Rates

• An extreme version of incentives is piece rate
  the manager is paid by the number of units
  produced.
• If the manager can control production measure,
  then risk is minimal.
• Must be able to measure output individually.

16
Flat Salary

• Managers pay does not depend on performance.
• In extreme case, manager has no incentive to work
  at all.
• However, if long-term performance can be
  observed, manager may be fired if performance is
  low.
• If pay is higher than opportunity cost, manager
  wants to keep job.

17
Using Stock Performance

• With fixed salary, independent of stock
  performance, manager may shirk.
• Incentive contract, based solely on stock
  performance, puts managers income at risk.
• Compensation based on stock price along with base
  salary reduces risk and rewards high effort.
• But manager may focus an short-term performance
  only.

18
Long-term Compensation

• Stock options reward effort which generates
  improved future performance.
• Stock options for other employees provide
  incentives if employees feel their behavior
  strongly affects stock price.
• Managers cannot sell stocks in large quantities
  without disclosure.
• How did Enron managers get around this?

19
Market Incentives

• Reputation as good manager increases value on
  employment market.
• Bad performance may eliminate future employment.
• Some managers become entrenched because of
  influence with board members.
• Firms with poor management are subject to
  takeovers which replace management.
• Why didnt these controls work for Enron?